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– February 24, 2015

Movements in the U.S. dollar can affect capital flows as much as trade flows. There are a number of ways the strengthening dollar can affect global capital markets and capital flows. A strengthening dollar—like any other appreciating asset—attracts foreign capital, and drives prices even higher. In addition, U.S. investors will find that a strengthening dollar can make foreign investing less profitable. But there is more to the story for U.S. investors, especially for fixed income investors.

The strengthening dollar creates winners and losers for issuers of dollar-denominated debt. To understand these dynamics think about “old debt” and “new debt.” By “old debt” we mean existing bonds and by “new debt” we mean newly issued bonds. Foreign issuers of U.S. dollar-denominated debt are servicing old debt with today’s weaker native currency. Under the circumstances, it takes more of the native currency to buy the required amount of dollars to make interest payments. As a result, issuers who already have a significant amount of “old” dollar-denominated debt outstanding may be at risk of default if they do not have the required amount of native currency. Thus, it would be prudent for U.S. investors review the credit quality of foreign issuers of dollar-denominated debt to be sure the issuer has sufficient capacity to service the debt.

If it is expensive to service “old debt,” the strong U.S. dollar also means it is more beneficial to raise native currency with “new debt.” Foreign governments and corporations looking to raise capital will be able to use the U.S. dollars from a new bond issue to buy more of the relatively weakened native currency. In this situation, U.S. investors may find opportunities in newly issued dollar-denominated debt as long as the issuer is high quality and will be able to service the newly issued debt, even if the dollar continues to strengthen. Historically, as the U.S. dollar strengthens, foreign issuers of dollar-denominated debt have taken the opportunity to convert dollars into relatively higher amounts of native currency (Chart 5).

Commodity prices and the strength of the dollar are intricately linked. Global commodities are priced in the U.S. currency. When the value of the dollar rises relative to other currencies, commodities become more expensive to foreign buyers who must purchase in the weaker local currencies, all else equal. The result can be reduced demand and potentially lower prices over time for the commodity. This relationship has been clear recently when we look at commodity prices and the performance of the dollar.

In general, the price of gold, the price of crude oil, and the price index for a broad basket of commodities have mirrored the dollar over the past 10 years (Chart 6). While the prices of the various commodities are broadly moving opposite to the performance of the dollar, the magnitudes of the moves are significantly different, both between the commodities themselves, and relative to the dollar. For example, since the end of 2004, the dollar index declined about 15 percent to its low in July 2011, only to reverse course and recover most of the decline. Over the same period, the various commodity prices rose as much as 300 percent to their peaks in 2011 and then declined anywhere from 30 to 50 percent.

In addition, the differences among the performances of the commodity prices reflect the disparities in the fundamentals for each commodity. Gold had the sharpest increase from the end of 2004 through its peak in 2011. The outperformance was particularly apparent from 2008 through 2011 as gold became a safe haven hedge against the unorthodox policy of the Federal Reserve. Concerns that the U.S. banking system was at risk or that quantitative easing (QE) might generate excessive inflation drove buyers to the safety of gold. As those fears eased and the dollar gained strength, gold prices fell by more than a third from its peak in 2011. Crude oil prices however, followed a somewhat different path. Crude oil rose sharply during the pre-recession years, driven by the strong global economy.

Crude prices collapsed sharply during the recession reflecting its sensitivity to levels of economic activity, and subsequently rebounded along with demand during the early part of the recovery. More recently, crude oil prices again fell sharply, this time in response to changes in global supply of oil (see out Business Conditions Monthly for January 2015 for our analysis of the changes in the oil market and the impact of the U.S. economy.)

Overall, we expect the continued strength in the dollar to add further pressure to commodity prices, but the exact impact will also reflect the unique underlying fundamentals of each commodity.

U.S. Equities:
The surging dollar may be a boon for consumers who reap the benefits of potentially cheaper imports, but it can be a burden for U.S. corporations. The companies most likely to feel the negative effects of a rising dollar are those that derive a large share of their revenue from international operations. These are more likely to be big multi-nationals that are typically found in large-cap equity indices such as the Dow Jones Industrial Average and the Standard & Poor’s 500 Index.

Standard & Poor’s estimated as of 2012 that more than 46 percent of S&P 500 members’ sales come from foreign markets. This number had steadily risen from around 42 percent in 2003. Certain industries are especially reliant on international revenue, such as information technology, for which foreign sources accounted for more than 58 percent of 2012 sales.

When we examine the components of U.S. corporate profits, we see that corporate foreign profits in the third quarter of 2014 (our last available data point) are estimated to be more than $400 billion. However, given the historical relationship between the dollar and total corporate profits derived from the rest of the world, we would expect to see a decline to somewhere in the $300 to $350 billion range (Chart 7).

Among the reasons for the decline:

• Exports generate relatively less revenue, in dollar terms. If corporations maintain prices in foreign currencies, they will bring in relatively less revenue, once it is converted to dollars – creating a price cut or discount on the value of those sales. If corporations want to maintain dollar revenue from abroad without increasing sales, they would need to raise prices in local currencies, which could slow demand. Either way, corporations can expect reduced foreign revenue and/or tighter margins.

• As the dollar gains against the local currency used in a foreign market, locally based competitors’ prices become cheaper in that currency relative to U.S.-produced goods. Foreign corporations that transact within their own markets will not need to make the same sacrifices vis-à-vis revenue and margins as their American counterparts. As locally made products become relatively cheaper than U.S.-produced goods, global demand for U.S. products may weaken.

• A strong dollar may signal weak global demand irrespective of exchange-rate fluctuations. One of the reasons that the dollar has surged is because expected global growth lags U.S. growth forecasts.

Global Equities:
Big U.S. multinationals commonly use a variety of hedging strategies to mitigate what they refer to as exchange-rate risk, as illustrated by the dollar’s rapid appreciation since June 2014 and its effects on revenue and profit. Hedging strategies can involve derivatives, options and forward contracts. For individual investors, there are two common ways to protect against currentcy fluctuations. First, certain exchange-traded products can provide a simpler and less expensive way to build some exchange-rate risk protection into an investment portfolio. For example, this means that the risk of a decline in value of certain holdings, should the dollar strengthens, can be offset by purchasing a fund that climbs when the dollar climbs. 

Second, some global equity and bond funds offer “currency-hedged” share classes. Where a global fund will be exposed to currency fluctuations based on the underlying holdings, currency-hedged share classes maintain the same holdings as the original share class but eliminate foreign currency risk using futures contracts.

The cost of hedging away currency risk is typically less than 5 basis points (0.05%) for most funds unless they have unusual currency exposures. Many investors find this low cost to be worth the potential for reduced volatility. Some investors are willing to accept the fluctuations associated with currency risk under the assumption that those changing values will even out over time and may even provide a boost during certain periods.

In light of recent currency volatility, it is important to understand whether the global stock and bond funds you own are exposed to these risks. A global fund of equities or bonds is exposed to the risk of the underlying holdings and also to the dollar exchange rate with currencies that are represented by those holdings. Given the recent strength of the dollar, American investors exposed to global currency fluctuations have seen weaker returns than investors who chose currency-hedged share classes. Chart 8 shows an example of the relative performance of both the currency-hedged and unhedged versions of typical global equity index and the monthly performance of the dollar.  Notice that as the dollar posts larger monthly gains, the hedged version of the index outperforms the unhedged version. In an environment where the U.S. dollar is strengthening and may continue to strengthen, investors may want to review their exposure to unhedged global investments.

Next/Previous Section:
1. Overview
2. Economy
3. Inflation
4. Policy
5. Investing
6. Pulling It All Together/Appendix

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