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The world is awash in issues today with troubles in the Ukraine and the Middle East taking center stage. The international currency market, however, has had its own drama unfolding, albeit rather quietly. The revaluation of the Swiss franc may have provided some theatrics; nonetheless, the larger story has been the rising American dollar these past six months. The overall dollar index has risen about 15% against a composite of world currencies over this time frame. Accordingly, first quarter 2015 earnings announcements have seen many S&P 500 companies issuing downward revisions to their earnings expectations for the rest of the year with the rising dollar being their reason.
The reasons for the dollar’s ascent have to do with the relative attractiveness of investment opportunities in this country vis-à-vis those in Europe and Japan. The slide in the euro and the yen may be seen as improving their nations’ export and economic prospects; however, it was not their intention to devalue their currencies. Rather, it had to do with 10-year U.S. government bonds paying 1.5% more than German government bonds and U.S. GDP growth vastly exceeding that in the Eurozone, whose economy is barely above a recessionary level. Even U.S. government finances are significantly better than those in the Eurozone where much of the continent still is involved in debt restructurings. The way things look, this scenario is not going to change soon. In fact, if the Fed follows through with its intent to raise interest rates this year, the yield spread favoring the dollar will only get larger.
In the most developed economies, countries with higher short-term interest rates that keep moving higher tend to have the stronger currencies. Demand for a currency increases as the yield curve differentials between countries pay people to own a given currency. This gives way to a phenomenon known as the “carry trade.” It works like this: you borrow short-term money in one currency, and you then convert it to another currency and then buy a bond in that currency. The idea here is to borrow at the lower interest rate and invest in a bond, short or long-term, at a higher yield. This presumes that the higher interest rate will not drop enough to reverse the interest rate spread during the period you hold the bond.
Also, it is important to borrow in a currency that you think won’t appreciate very much against the higher interest rate currency in which you will buy your bond. Herein lies the risk that you could lose in currency movement more than you earn in interest rate differential. If making money this way were so simple, everyone would do it and soon it no longer would be possible due to arbitrage. On the other hand, if your acquired currency appreciates due to increased demand, you will get the double benefit of appreciation plus yield differential.
Currency Impact on Stocks
If you are holding foreign securities when the dollar is strong, like today, those securities will show a higher return. You do not have to hold foreign securities directly; rather, you can simply hold the American Depository Receipts of foreign companies traded on the New York Stock Exchange and the NASDAQ. Over the long run, since currencies are cyclical, the net currency effect is approximately zero. Is there a trading opportunity here? Is a strong dollar good for stocks and is a weak dollar bad? A look at the historical stock price returns just does not bear this out. Stock returns can be strong or weak whether the dollar is rising or falling. This is true worldwide; currencies do not indicate the direction of stock prices and stock prices do not predict currency movements.
The fact that many people do not believe this can create its own contrarian investment opportunity. Sometimes prognosticators and market gurus predict bear markets based on a declining dollar. If you know that the dollar’s direction does not predict stock price movements, you have the wherewithal to bet against such a prediction since false “facts” will create their own opportunity for those who don’t believe them.
Currency exchange rates are determined by supply and demand. Currencies are no different than other commodities in that their prices are determined by their relative supply and demand vis-à-vis one another. Currency movements can be very volatile and an investor should not care much about what any currency does from month to month.
Kenneth N. Green is Senior Vice President and Director of Investment Research for Marc J. Lane & Company and Marc J. Lane Investment Management, Inc. Mr. Green is a graduate of the University of Michigan (M.B.A.) and the University of Illinois at Urbana (B.S.). Mr. Green is also a Certified Public Accountant (CPA).
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