The first month of 2017 hasn't been kind to U.S. dollar bulls. After a scorching run higher late last year, the mighty greenback trended lower throughout January. A variety of factors tend to drive movements in the U.S. dollar index, such as interest rate expectations and the relative economic growth rates of the U.S. versus Japan, the Eurozone and other economies.
One key factor which may have stunted the U.S. dollar index rally is the expectation of rate hikes from the U. S. Federal Reserve. "We had the dollar surge based on the election and more importantly on the December rate hike," says JJ Kinahan, chief market strategist at TD Ameritrade. "Now we don’t see a high probability for another rate hike until May," Kinahan adds.
What Exactly Is the Dollar Index?
A quick primer: The U.S. dollar index is a measure of the value of the U.S. dollar against a basket of currencies that are freely traded and belong to our largest trading partners. The basket of currencies includes:
- the euro with a 58% weighting,
- the Japanese yen at a 14% weighting,
- smaller weightings for the British pound, Canadian dollar, Swedish krona and Swiss franc.
The Economic Winds May Be Shifting
It's not just the interest rate expectations that are weighing on the dollar index, but the comparative growth outlook may have shifted too. In recent years, the value of the U.S. dollar index gained ground from increasing U.S. economic strength relative to those of the eurozone and Japan.
Now that may be changing. "Recently, both the eurozone’s and Japanese economic growth and inflation readings have surprised to the upside. Investors have begun to recognize the increasing relative strength in both the eurozone and the Japanese economies and have thus sold the U.S. dollar since the beginning of this year," explains Henry To, partner at CB Capital Partners.
The Earnings Headwind May Be Easing
A few U.S. multinational CEOs might be breathing a sigh of relief on the dollar's latest retreat. "In the fourth quarter earnings releases some CEOs were still citing the stronger dollar as a headwind for earnings; that included Caterpillar and Boeing," Kinahan says. If the U.S. dollar can stabilize or continue to ease, it may help the sales and earnings outlooks of some of these multi-national companies, Kinahan adds.
What Might Lie Ahead for the Greenback?
After the strong rally in in the second half of 2016, which propelled the U.S. dollar index from a low around 92.00 to its recent high around 103.75 in early January, the greenback could be settling into a range. "I believe the U.S. dollar index will be in a holding pattern and trade in a range of 95 to 105 in 2017. Reasons for being positive or negative on the U.S. dollar index cancel each other at today’s level," To says.
The bullish dollar argument: The strong domestic energy picture, which includes U.S. shale oil production, is a factor that helped the U.S. trade deficit shrink in the last two years, To says. "Now OPEC has agreed to a six-month cut of 1.2 million barrels per day, U.S. oil production is increasing again, thus negating the need to import more oil. The innovation and strength in the U.S. oil economy has singlehandedly saved our economy by increasing energy security and in turn, boosted confidence in the U.S. dollar," To says.
The bearish dollar argument: There are risks to the downside for the dollar ahead. Financial markets have priced in a lot of economic growth expectations from the new Trump Administration surrounding proposed tax cuts and fiscal spending, and U.S. interest rates have climbed recently on that view.
"This spike in interest rates has resulted in a substantial slowdown in U.S. bank lending over the last several months," To notes.
"If the promised tax cuts or fiscal spending don’t appear soon, U.S. economic growth could disappoint due to the spike in interest rates. This means the Federal Reserve will need to again step back from its proposed schedule of hiking the fed funds rate three times this year. Should the Fed step back from its hiking schedule, investors will respond by selling down the U.S. dollar," To explains.
The Dollar and Your Portfolio?
If the current pullback in the U.S. dollar proves to be a short-lived correction, a rising dollar trend could mean you have to be more selective about your investments, To says. "About 30 percent of profits of large U.S. corporations come from overseas markets. Should the U.S. dollar continue to rise, this will result in slower U.S. corporate profit growth."
Kinahan explains how U.S. stock investors can potentially minimize the effects of a rising dollar on their portfolio. "Stay with companies that primarily have domestic sales," he says. Many small-cap stocks primarily have domestic exposure, which limits impact from currency fluctuations on their portfolio. "The problem is that you may be limiting yourself by doing that, as the bigger companies often have international exposure," Kinahan explains.
Kinahan points to the Company Profile page as a useful tool when analyzing the potential impact from the U.S. dollar trend on their investments. (See figure 1 below)
Lastly, says To, "I would avoid investing in companies that derive most of their sales from overseas markets, or companies that benefit from rising precious metals or commodity prices, as a rising U.S. dollar trend tends to depress precious metals and commodity prices."