Dollar continues to call the shots worldwide

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Saint Augustine of Hippo is well-known for works such as Confessions and The City of God but the fourth century AD Christian theologian may be most famous for his prayer “Grant me chastity and continence but not yet.” Uttered as he looked to embrace Christianity and the priesthood – and thus celibacy – these few words highlighted Augustine's choice between vice and virtue and on a more worldly stage the US Federal Reserve faces a similarly prickly dilemma, whose implications are as real as they are philosophical.

There seems little doubt that Fed chair Janet Yellen would like to increase interest rates from the record low of 0.5%, at which they have been anchored for over six years. Unemployment is falling and the US central bank will be only too well aware of the potential damage to savers, pensions and financial institutions that could result from derisory returns on cash, the asset class which has shortest duration and forms the basis for all considerations of whether the risk related to an investment is worth it or not (relative to the returns available from the folding stuff).

However, a strong dollar and a soggy US economy are refusing to play ball. The jobless rate is coming down but this is a lagging indicator. Moreover, inflation remains way below the Fed's 2% target, leading economic indicators such as business sentiment surveys, look soft and concurrent indicators such as retail sales, industrial production and durable goods orders are also failing to inspire confidence.

If the Fed did raise rates, the dollar would soar, in all likelihood, especially as Europe and Japan continue to run aggressively stimulative monetary policy through their Quantitative Easing schemes. A surge in the dollar would have three potentially incendiary consequences:

  • It would hardly help the US economy, American corporate earnings or – by extension – the Dow Jones, S&P 500 and other equity benchmarks over the pond.
  • It would annoy the Chinese, whose currency is pegged to the buck. Beijing could conceivably look to break that peg and devalue, to the doubtless fury of competitors such as the US, Japan and Europe alike. A Chinese devaluation would also be deflationary for the rest of the world.
  • It would make life very awkward for those who have borrowed in dollars, as their debts would become more expensive to service in local currency terms. Latin America was caught out here in the 1980s and Asia in the 1990s. Governments may have learned their lessons from these crises but corporations may have neglected them.

All of these make it hard for the Fed to raise rates, no matter how much it wishes to do so – the inter-connected nature of markets means there will be ramifications somewhere. In the end the Fed's mandates are domestic and even here the picture is less certain than it was. Perhaps clients and advisers are focussing on the wrong narrative – not when the Fed raises rates in 2015, but if.

If recent market action is any guide that could leave clients scrambling in the short term to try and generate a (relatively) dependable yield and searching for reliable equity dividends and fixed-income coupons. It would help long-duration bonds, commercial property and stocks with decent yields to maintain their strong run, to the potential (relative) detriment of emerging market equities, cyclical stocks and anything with a commodity tilt.

Longer term the picture remains muddy. Central banks want inflation as that is the easiest way to deal with the huge debt burden which still saddles the globe and is weighing on economic growth. It would be therefore perhaps unwise to bet against them getting their way on a long-term view, despite the growing likelihood of deflationary scare this year, and that scenario points to inflation-linked bonds and possibly gold as two ways forward. Advisers can add value by outlining the possible endgames and how clients can seek to protect their wealth, according to their own preferred time horizon, target return and appetite for risk.

Lagging indicators

America is the world’s largest economy and home to its deepest, most liquid bond and equity markets, so advisers and clients need to keep a close eye on event Stateside. The drop is US unemployment is held up as the most likely reason why the Fed will raise the cost of borrowing in 2015 – but keen students of the American central bank will remember that in 2012 a jobless rate below 6.5% was deemed to be one potential trigger for monetary policy, while in December 2013 chair Janet Yellen noted the number would have to be well below 6.5%. Well, the number has kept improving yet the Fed has not acted

The headline (U-3) unemployment rate is now 5.5%. Perhaps the broader U-6 measure, which includes those who have been jobless for more than a year and have given up looking, is a better indicator, as it still stands at 10.9%, at a time when the overall labour participation rate stands at a multi-decade low of 62.7%.

Headline US unemployment rates continue to slide

Headline US unemployment rates continue to slide

Source: www.bls.gov

Even here, there is some progress, even if the March non-farm payrolls number of 126,000 disappointed, providing the weakest reading since January 2014.

Non-farm payrolls needs to bounce back from weak March showing

Non-farm payrolls needs to bounce back from weak March showing

Source: www.bls.gov

That March reading cannot be blamed on a vicious US winter so again, clients need to be on the guard, especially as the decent readings through the winter must be seen as lagging indicators. Just think of how long it takes any firm to hire – it must feel confident (and profitable enough) to do so, then go through the interview process, make an offer and so on. This all takes months.

Concurrent indicators

Advisers and clients should perhaps therefore pay more attention to concurrent indicators – retail sales, industrial production and durable goods orders. It is therefore of some concern that the latest trends in the US again suggest softness rather than a robust economy.

US retail sales have dropped four times in seven months, despite oil weakness

US retail sales have dropped four times in seven months, despite oil weakness

Source: Thomson Reuters Datastream, www.census.gov

US industrial production has dropped three times in four months

US industrial production has dropped three times in four months

Source: Thomson Reuters Datastream

US durable goods orders have dropped five times in seven months...

US durable goods orders have dropped five times in seven months...

Source: Thomson Reuters Datastream, www.census.gov

...and for five months on the trot excluding transportation

...and for five months on the trot excluding transportation

Source: Thomson Reuters Datastream, www.census.gov

Lead indicator

Stock, bond and commodity prices should all be good lead indicators, as financial markets are supposed to be forward-looking discounting mechanisms. Equity markets are moving higher but bond yields and commodity prices are dropping so advisers and clients are getting a split decision at best, at the moment, so it may pay to keep a close watch on key sentiment measures, as the national and local level. Besides America’s nationwide purchasing managers’ index, some of the local branches of the Fed publish their sentiment surveys. The latest results from Philadelphia, New York and Dallas do not read too well.

Empire State manufacturing survey...

Empire State manufacturing survey...

Source: Thomson Reuters Datastream

Philly Fed manufacturing survey...

Philly Fed manufacturing survey...

Source: Thomson Reuters Datastream

...and Dallas Fed survey all point to a soft spot in US economic momentum

...and Dallas Fed survey all point to a soft spot in US economic momentum

Source: Thomson Reuters Datastream

Dollar dilemma

With US economic momentum open to some question, even allowing for February’s rotten weather, the Fed may think twice before raising rates. American corporate bellwethers such as Intel, Johnson and Johnson and GE are all flagging the negative impact of dollar strength upon their earnings. If the Fed did hike, the greenback could soar, especially with the Eurozone and Japan still committed to Quantitative Easing (QE) and tacit policies of devaluation. The buck has surged from 80 to 100 over the past 12 months, using the trade-weighted DXY basket as a benchmark, but this reading reached 120 in the 1990s and nearly 160 in the 1980s. Using these historic guides, the US currency could run further still.

Interest rate cuts and a recession took the steam out of the dollar in the late 1990s and early 2000s but it took September 1985’s Plaza Accord amongst (what was then) the G5 to officially devalue the greenback against the yen and deutschmark to halt its progress 30 years ago. Clients should therefore keep listening to the level of American corporate bleating about dollar strength as the Fed might just decide a weak currency is needed to help growth, putting a rate rise on hold for some time to come, further starving savers of welcome income.

Russ Mould, AJ Bell Investment Director.


russmould's picture
Written by:
Russ Mould

Russ Mould has 28 years' experience of the capital markets. He started at Scottish Equitable in 1991 as a fund manager and in 1993 he joined SG Warburg, now part of UBS investment bank, where he worked as equity analyst covering the technology sector for 12 years. Russ joined Shares in November 2005 as technology correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media by AJ Bell Group, he was appointed AJ Bell’s Investment Director in summer 2013.