The U.S. dollar continues to be a big story for investors as it remains one of the primary drivers of the global economy. The U.S. dollar began the year in a very strong position but has weakened considerably as the U.S. economy has continued to weaken.
To some extent, a weaker dollar has given breathing room to beaten down sectors of the U.S. economy such as energy and manufacturing.
U.S. manufacturing in general has suffered greatly from the strong dollar as it has made U.S. exports less competitive. However, manufacturing has enjoyed a short-term reprieve during March and April (as the dollar weakened) but that appears to be waning as we head into the summer months. The ISM manufacturing index is considered the best indicator to determine the health of the manufacturing sector. A reading above 50 indicates that the manufacturing sector is growing, while any number below 50 indicates contraction. As you can see in the illustration below, the manufacturing sector went through a prolonged period of contraction in late 2015 and early 2016 and is nearing contraction once again based on regional manufacturing surveys that came out in May.
Since the value of the U.S. dollar is so important, one must ascertain if the rally in the U.S. dollar is over. We believe that the primary driver of the strong dollar is the policy divergence between the U.S. and other global central banks. To that end, the Federal Open Market Committee (FOMC) began effectively tightening policy when Quantitative Easing (QE) ended. The FOMC tightened again when it raised the target for the Fed Funds rate by 0.25% in December 2015. This might not seem like much on the surface, however, based on analysis by the Federal Reserve, its cumulative effect is substantial. Below is an illustration of the estimated aggregate effect of the FOMC's aggregate policy actions called the "Wu-Xia Shadow Federal Funds Rate."
The illustration indicates that the combination of ending QE and raising the Fed Funds rate in December by 0.25%, has resulted in an effective tightening of monetary policy equal to 3.25%. Historically, a tightening of 325 bps would be commensurate with an entire tightening cycle by the Fed. However, with rates still close to zero, the FOMC is determined to increase rates further to normalize interest rates. Without normalizing rates, the FOMC would have little ammunition to fight future contractions in the economy and would have to rely more on fiscal policy stimulus.
The divergence created by the U.S central bank, which is currently in a tightening mode, coupled with the rest of the world largely still in an aggressive easing mode, continues to lend support to a stronger U.S. dollar. In fact, based on minutes from the April FOMC meeting and numerous comments from FOMC governors/presidents, the FOMC intends to raise rates again in the coming months. These comments have already resulted in the U.S. dollar rallying strongly over the last week.
A stronger dollar
In conclusion, we expect that the U.S. dollar will continue to strengthen over time, however, we expect currency moves to remain volatile. As such, a stronger dollar will continue to create headwinds for U.S. multinational corporations and manufacturing, which in turn will keep a lid on earnings growth. However, at some point, this central bank policy divergence will begin to dissipate. There is gaining momentum that the negative interest rate policy employed by Japan and Europe is deflationary. If that proves accurate, then those central banks may be forced to unwind those policies as the market forces their currencies higher. Nonetheless, we are not yet to that point and, as such, the strong dollar looks poised to continue its rally over the coming months.
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Disclaimer: This blog is intended for informational purposes only and should not be construed as individual investment advice. Actual recommendations are provided by RAA following consultation and are custom-tailored to each investor’s unique needs and circumstances. The information contained herein is from sources believed to be accurate and reliable. However, RAA accepts no legal responsibility for any errors or omissions. Investments in stocks, bonds, and mutual funds may increase or decrease in value. Past performance is no guarantee of future results. Any of the charts and graphs included in this blog are not recommendations for the purchase and sale of any security.