Travis Gallton, The Daily Record Newswire
It has been 19 months since the U.S. Federal Reserve (Fed) completed its historic quantitative easing program. Since then, the S&P 500 Index has experienced a total return of approximately 6.4%. Conversely, the U.S. 10-year Treasury note’s yield has fallen over 48 bps, with a total return of 9.1% (a basis point is one hundredth of one percent or 0.01%), and the U.S. dollar (USD) has appreciated over 10.9%. Clearly these are not exactly markers of a resilient global economy that tend to be characteristic of when the Fed begins tightening.
In fact, until the middle of February the USD had rallied over 20% since the middle of 2014. In a global marketplace, the drastic appreciation of the USD has hurt U.S. manufacturing and exports because it has made them much more expensive. After such extreme moves, we have seen companies regularly cite the negative impact of exchange rates causing earnings weakness.
To recap this powerful move made by the USD let’s look at what drives a currency. Typically, economies that are growing faster than others command more investment, and thus generate capital inflows. This ultimately results in an appreciating currency. Indeed, this is exactly what has been happening, as the U.S. economy has been growing by 2.0% while the Euro zone and Japan have grown at 1.6% and 0.7%, respectively (Source: Bloomberg Finance, L.P.).
Additionally, higher interest rates garner more attraction from global investors. As U.S. Treasuries trade with higher yields than most other sovereign bonds, this has also been a major contributing factor causing the USD to appreciate.
However, in the middle of February, the Fed changed its tune on expected rate hikes and since the USD’s appreciation has taken a pause. In fact, contrary to popular belief, the Fed hiking interest rates is not supportive of the USD. In five of the past six Fed initial hiking cycles, the USD was lower three months later.
To complicate matters, the European Central Bank (ECB) and Bank of Japan (BOJ) have surprised markets by doubling down and taking interest rates negative. Today, there are approximately $7.9 Trillion of sovereign bonds trading with negative nominal rates, which is roughly 33% of the Bloomberg Global Developed Sovereign Index.
Even with these extreme measures taken by the ECB and BOJ, the Euro and Yen have appreciated against the USD, which has prompted Japan to make recent comments to depreciate their currency. This has provoked U.S. Treasury Secretary Jacob Lew to “warn of the risk of currency battles wreaking havoc on the global economy…and to reiterate their commitments against exchange rate devaluations’’ (Tralley, Ian. “Jacob Lew Warns of Risk of Currency Battles Hurting Global Economy.” 13 May 2016. The Wall Street Journal. Web. 19 May 2016 ).
Negative rates are essentially a tax on investors because they lock in negative total returns if the bond is held to maturity. In fact, by trying to avert deflation through negative rates, conditions for deflation become evident because investors withdraw liquidity and hoard cash rather than invest. This can be seen in Europe and Japan today, where monetary stimulus has had little impact on bank lending because money is not channeling into the real economy.
With all of these conditions in place, investors are left wondering how their portfolio will potentially be impacted. The recent sell-off in the USD has led to swift gains in commodities, high yield debt, and emerging markets. If the Fed changes over to a more hawkish tone in the second half of the year, the USD could move higher putting new pressures once again on risk assets.
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Travis M. Gallton, CFA, is a senior equity portfolio manager for Karpus Investment Management, a local, independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. Offices are located at 183 Sully’s Trail, Pittsford; or call 585-586-4680.
