Jan. 18, 2015 5:22 AM ET
Summary
- The dollar continues to rise against most leading currencies.
- This tends to drive down commodity prices, make exports less attractive and create an increased danger of deflation.
- It is also likely that, if the trend continues, the Fed will be cautious about raising rates.
- A strong dollar is generally good if it is a sign of a strong U.S. economy but can be bad if it is a sign of international panic.
- Investors should focus on companies that do business in the United States and provide stable cash flow; BDCs and REITs are attractive on this basis.
| 1 year low | 5 year low | 10/10/14 | 1/16/15 | |
|---|---|---|---|---|
| Japanese Yen | 96.9 | 76.1 | 108.4 | 117.6 |
| Euro | .718 | .679 | .785 | .865 |
| Loonie | 1.03 | .94 | 1.12 | 1.20 |
| Indian Rupee | 58.4 | 44.2 | 61.4 | 61.9 |
| Australian Dollar | 1.03 | .91 | 1.14 | 1.21 |
The dollar's continued appreciation against almost all other currencies makes it harder for U.S companies to export and to compete against imports, discourages travel to the United States and encourages Americans to travel abroad, and increases the danger of deflation. In the distant past, tariffs and trade barriers would mitigate some of these impacts, but the world's commitment to free trade makes currency the only real mechanism governments still have to protect domestic industries. December's inflation numbers were at recent lows and deflation will become an increasing concern of policy makers.
The Swiss Action - Switzerland surprised everyone this week by abandoning its implicit "peg" to the Euro. The Swiss franc exploded on the high side and pundits were left scratching their heads. I am not sure what the thinking behind the action was but I see it as a small positive for the United States. First of all, it means that at least one currency is not likely to depreciate against the dollar and that imports from Switzerland will not get cheaper and cheaper. More importantly, it restores the Swiss franc as a "strong" and safe currency which will hopefully mean that some of the money which has been going into the dollar (and pushing it up) every time there is a tremor on the international financial scene will go into the Swiss franc instead. Thus, I see the recent Swiss action as a positive development - although, given the size of the Swiss economy, only on a very small scale.
Will China "Go Swiss"? - A much more important implicit "peg" has been the Chinese policy of keeping the yuan at a rate between 6.1 and 6.2 to the dollar. China must be beginning to experience "strong dollar pain" as its currency goes up against virtually everything else in the world with the dollar and as it becomes harder and harder to export to Europe, Canada, Japan, and virtually everyplace else. The danger is that China will abandon the peg in exactly the opposite direction of the Swiss and resume a policy of pushing its currency down by buying and holding ever increasing amounts of dollars. China is, of course, a much bigger economy than Switzerland and this action would have a number of negative consequences. It would almost certainly push the dollar generally higher and it would make it harder for U.S. businesses to sell into China. It is a development to watch for because it could roil equity markets and reinforce deflation dangers.
Oil - Cheap in Dollars - We tend to look at the world through the "dollar window" and oil appears to be getting cheaper all the time. Although oil prices have come down as denominated in virtually any currency in the world, they have not been coming down as fast in many other currencies because - just as dollar denominated oil prices have declined - other currencies have declined against the dollar as well. So, while it is true that Europeans and Canadians are seeing much lower oil prices, the decline is not quite as sharp as it is in the United States. This may be one factor limiting the demand response to lower prices.
Financial Distress - In addition to the recent concern about oil and gas loans, we may begin to see more and more concern about dollar denominated loans to foreign debtors who will have an increasingly hard time repaying the loans with funds generated by sales or tax collections in local currencies which have been depreciating against the dollar. Unfortunately, this kind of financial panic could create yet another impetus for the dollar to appreciate as the dollar has been the favorite "risk off" currency since the 2008 Panic. Indeed, I could see a confluence of events unfold in which some noteworthy defaults led to a scramble into the dollar leading to even more defaults leading the Chinese to abandon the peg and resulting in a nasty self-reinforcing spiral.
Deflation Is No Joke - Whenever I write a macro article, I always get numerous comments arguing that deflation is good, deflation is no problem or deflation will never occur. I think that actual deflation (as opposed to disinflation) could be an absolute disaster. First of all, deflation makes it harder for all debtors to pay back their debts because it reduces the number of nominal dollars generated by various activities and the debts must be repaid in nominal dollars. Secondly, deflation tends to produce unemployment because wages are "sticky" on the downside (it is hard to implement an across the board wage cut) and so labor becomes more expensive during a period of deflation leading employers to seek aggressive steps to reduce head count. Deflation also tends to cause consumers to defer discretionary purchases waiting for the price to come down further and this reduces consumer spending. It is very easy for deflation to generate a recession leading to increasing deflation, a deepening recession and producing a death spiral for the economy.
Ammunition Is Low At The Fed - If this process develops as feared, the normal tools at the Fed's disposal may not be sufficient to prevent the carnage. The Fed cannot lower the fed funds rate below zero although it could change the wording of its statement concerning the timing of a rate hike. I would anticipate that we may see action of this kind soon. The Fed could always resume quantitative easing but that could be politically controversial. If a panic developed, the Fed could expand swap lines in cooperation with foreign central banks.
Other Policy Measures - I believe that there are other policy measures that could be implemented but they might require a political consensus and that may prove impossible.
Certainly, a massive tax cut, combined with quantitative easing to absorb the additional Treasury bonds that would have to be issued, would stimulate demand and might mitigate the dollar's appreciation. In addition, the government could use newly created money to stockpile commodities including an expansion of the Strategic Petroleum Reserve, gold purchases by the Federal Reserve, and expansion of stockpiles of strategic metals like chromium and platinum.
Finally, the Treasury could issue longer duration (50 year and 100 year bonds) and even consoles at periods of time when the flight to the dollar is particularly pronounced.
Investment Implications - The strong dollar has the result of making almost everything in the world go down when viewed through the "dollar window." This is certainly the year to travel aboard (my wife and I are going to the South of France but holding off on booking hotels until the Euro goes down some more). In the stock market, the focus should be on reliable sources of cash flow with minimal reliance on foreign earnings. In this regard, I continue to like REITs like Lexington Property Trust (NYSE:LXP) and Hospitality Properties Trust (NYSE:HPT). BDCs are also attractive - I like American Capital (NASDAQ:ACAS) and Ares Capital (NASDAQ:ARCC). The big telecoms - AT&T (NYSE:T) and Verizon (NYSE:VZ) should also hold up well. Although treasuries have had a run, they may run some more and an exposure to long bonds may help buffer a portfolio against the dangers described above.
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