If you turn on the news, it won’t be long before you hear someone mention the “strong dollar.” But what does that mean, and why does it matter? Today, we ask Robertson P. Breed, CFA®, a Portfolio Manager and member of our investment team, for some background and insight.
What does it mean when the dollar is “strong”? Isn’t a dollar a dollar?
Robertson P. Breed, CFA®:
Yes, a dollar is a dollar here in the U.S., but the value of a U.S. dollar versus other currencies varies day to day. A strong dollar simply means that the U.S. dollar is gaining value versus another currency (i.e.: the Euro) or basket of currencies (i.e.: the Dollar Index, a basket of U.S. trade partners’ currencies).
What happens to make the dollar “stronger” or “weaker”?
RB: In the simplest of terms, the U.S. economy’s performance drives the demand – or lack of demand – for dollars,
thereby creating a “strong” or “weak” dollar, respectively. If the U.S. economy is strong and its financial markets are considered safe (relative to other countries or regions), the dollar is likely to rise. If the converse is true,
the dollar is likely to fall.
Interest rates – relative to interest rates in other parts of the world – are another key factor driving the value of the dollar. Higher interest rates in the U.S. would attract investors seeking higher yields on their investments, increasing demand for the dollar.
Finally, geopolitical risk and market psychology can also influence the value of the dollar. The U.S. dollar is widely considered to be the world’s “reserve currency”: the currency in which most international transactions are settled and in which major central banks around the world hold much of their reserves. When economic and/or geopolitical risk increases globally, the dollar typically
strengthens as investors flee to the safety of the world’s “reserve currency.”
How does this impact the U.S. Economy?
RB: A stronger or weaker dollar doesn’t necessarily make the U.S. economy stronger or weaker, per se. In fact, the dollar really takes its cues from the economy. However, a dollar that is too strong makes U.S. exports more expensive for foreigners. This may lead them to buy cheaper products from another country, creating a negative impact on the U.S. economy.
Consider an example: Airbus (a European company) and Boeing (an American company) both build and sell aircraft. If the dollar rises 20% versus the Euro, all else equal, the Boeing planes have just become 20% more expensive for European airlines to purchase. This creates a dampening effect on Boeing’s ability to sell airplanes overseas – a negative for the U.S. economy.
Conversely, a 20% decline in the dollar would make the American product “cheaper”, which could lead to increased sales, production, jobs, and income in the U.S. In such a case, a weakened dollar could create positive ripples in the U.S. economy.
How does this impact my portfolio?
RB: Knowing whether the U.S. dollar is rising or falling is an important factor in portfolio construction. If your home currency is strong relative to foreign currencies, you generally want to “stay home” with your investments. Focus most – or all – your stock and bond
investment on U.S. stocks and U.S. bonds. A strong dollar environment can create a headwind for returns in international investments.
Imagine you made a 10% profit in a European stock index fund. During the same period, imagine the Euro lost 10% of its value against the U.S. dollar. While your optimism on European stock prices proved correct, the sinking value of the Euro erased your gains when your investment was converted back to dollars.
Conversely, when the U.S. dollar is weak, investing overseas can become increasingly appealing. In the above scenario, imagine the 10% appreciation in European stock being enhanced by a 10% depreciation in the value of the dollar. Compared to when you made the initial investment, it now takes more dollars to make a Euro. Converting your Euro investment back to dollars, then, would
result in an additional 10% return on investment.
So, what should I do with this information?
RB: Knowing when the dollar is strong or weak should inform how your portfolio is structured (i.e. your asset – and sub-asset-class – allocation). Talk to your portfolio manager to see how your account should be positioned to optimize for the relative strength of the
U.S. currency.