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Strong-Dollar Policy and Rate Hikes—a New Conundrum?

April 20, 2017
Chessboard Conundrum: Fed Rate Hikes and Strong Dollar Policy
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For the chieftains of some behemoth U.S. multinational corporations, President Trump’s declaration to the Wall Street Journal last week that “our dollar is getting too strong” likely was music to their ears.

Some Federal Reserve members, however, may have cringed. The link between interest rates and a robust greenback tends to be a solid one, and the president’s leaning toward a low-rate environment might be muddying the waters for the Fed’s plan to raise the federal funds rate at least two more times this year.

“The basic economics that folks sometimes forget is that your home currency, in this case, the dollar, is highly related to your interest rates,” says JJ Kinahan, chief market strategist at TD Ameritrade. “When interest rates go up, your currency is worth more than other currencies; when other countries devalue currency, they often cut rates.”

What a Strong Dollar Might Mean

Though a strong dollar can improve the purchasing power for U.S. consumers, particularly those traveling abroad and purchasing foreign goods, it often presents a costly quagmire for multinationals that generate much of their sales and income outside the U.S. A stronger dollar makes U.S. goods and services more expensive abroad. Plus, the exchange back into dollars can dent both the top and bottom lines of corporate earnings. Some analysts have estimated that every 10% rise in the value of the greenback shaves some 3 to 5 percentage points off the S&P 500’s earnings growth.

Trump, who has used debt as a means to build his business empire, has long been a fan of low interest rates. In an interview published last week, Trump took some of the blame himself for the rise of the dollar.

“I think our dollar is getting too strong, and partially that’s my fault because people have confidence in me,” he told WSJ. “But that’s hurting—that will hurt ultimately,” he added. “Look, there’s some very good things about a strong dollar, but usually speaking, the best thing about it is that it sounds good.”

“It’s very, very hard to compete when you have a strong dollar and other countries are devaluing their currency,” he added.

The Foreign Exchange Sting

Indeed, the foreign exchange bite from weaker currencies into dollars can be a big one. Consider the currency smack for Apple (AAPL): Last year, the consumer electronics juggernaut said it rang up 66% of its Q1 revenues outside the U.S. The strength of the dollar—which at that point had not yet hit the 13-year high it would mark after the presidential election—put a nearly $5 billion dent in Q1 revenue. AAPL reported its top line revenue at $75.9 billion, but noted in its earnings report that in constant currencies it would have been $80.8 billion. That knocked its sales growth down a few notable notches to 2% instead of 8%, according to the company’s release. In Europe alone, an 18% sales gain in constant currencies was reduced to 4% when adjusted for changes in foreign exchange rates.

That’s apparently what Trump is talking about when he says “it’s very, very hard to compete when you have a strong dollar.”

Meanwhile, the Fed, which prides itself on being an independent agency without political ties, is trying to keep the economy growing while keeping inflation in check, which can at times be tricky juggling act. When it last upped the federal funds rates in March, to a range of 0.75% to 1%, Chair Janet Yellen indicated that more increases were in the offing as the Fed looks to get back to “normalization” in monetary policy.

“We continue to expect that the ongoing strength of the economy will warrant gradual increases in the federal funds rate to achieve and maintain our objectives,” she told reporters at a press conference after the rate hike was announced. “That’s based on our view that the neutral nominal federal funds rate—that is, the interest rate that is neither expansionary nor contractionary, and keeps the economy operating on an even keel—is currently quite low by historical standards. That means that the federal funds rate does not have to rise by all that much to get to a neutral policy stance.

“Even so, the committee continues to anticipate that the longer-run neutral level of the federal funds rate is still likely to remain below levels that prevailed in previous decades,” she said, adding that the Fed’s projections for the federal funds rate is 1.4% at the end of this year, 2.1% at the end of 2018 and 3% by end of 2019.

What’s the Fed to Do?

Can the Fed stay on that track when the president is crooning about a low-interest environment? Remember, too, that a strong dollar is not indicative of a strong economy. It’s a reflection of the dollar’s value against other currencies.

“Was that a one-time statement by the White House or is this something where the power of the pulpit might influence the Fed into kicking the can down the road on rate hikes,” Kinahan asks.

The markets aren’t too sure, according to CME Group’s FedWatch tool. The probability of a 25-basis point rate hike by June, based on the 30-day Fed Funds futures prices, has fallen from nearly 58% last week to 48% as of Monday. But a step up by July is still over the 50% mark, at almost 54%. Meanwhile, bonds continue to show weakness, with 10-year Treasury notes falling to 2.22% while commodities, which tend to be extremely dollar sensitive, are shooting up. 

As earnings seasons unfolds, Kinahan says to pay close attention to what chief executives of multinationals are saying on conference calls about the dollar and their forecasts of  its impact on their results.

“The next few weeks are key to watch in terms of whether the dollar’s strength will influence the Fed,” he says. 

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