There is a peculiar recent trend you may have noticed. Over the past month or so, the dollar has increased by about 2.3% against a basket of foreign currencies. This doesn’t sound like a whole lot, but it’s a fairly meaningful move in a short period of time. At first blush, the strength in the dollar isn’t hard to explain. The US economy is on a tear right now, with most economists expecting growth of 7% or more for the year. This rate of growth is huge not only compared to historical levels, but it’s also much more robust than almost anywhere else on the globe right now (the Chinese economy is now slowing after being the first to emerge from the pandemic). Economic growth expectations are one of a number of factors that cause exchange rates to fluctuate, with stronger rates of growth correlated to a stronger currency.
Just as the dollar would be expected to strengthen as the economy gains strength, it would also be expected to weaken in response to a significant drop in interest rates. This is fairly straight-forward as well. Money tends to move to where it can earn the highest returns. If yields on US Treasury bonds unexpectedly rise, we would normally expect the dollar to strengthen as foreign investors convert their currencies into dollars so they can buy US bonds. But as you can see in the first chart below, the dollar has strengthened in recent weeks even as Treasury yields have dropped to multi-month lows. What gives? If interest rates are falling, shouldn’t the dollar be falling as well to reflect the lower returns available on US fixed-income investments?
The explanation is that the nominal interest rate has two components: 1) inflation, and 2) the inflation-adjusted, or “real” interest rate. We need to examine these two components separately to explain why the dollar has been strengthening against the backdrop of falling interest rates. Let’s start with the first component, inflation. Inflation should move inversely to the dollar. Intuitively, this makes sense. If it costs more dollars to buy a given good or service, then the value of the dollar has declined. Easy enough. But now comes the tricky part: What metric should we use to gauge inflation? We could use the CPI or PCE, both which have spiked in recent months. But those metrics are backward-looking and not reflective of what’s expected in the future. A better metric for gauging inflation is the “breakeven” inflation rate, which is a market-based measure of inflation expectations for the future rather than a gauge of current inflation rates. The 10-year breakeven inflation rate, in contrast to both CPI and PCE, has actually been falling for the past few weeks, from a high of 2.56% in mid-May to the current 2.36%. The drop means that investors are now expecting inflation to be lower over the next 10 years than they expected just a few weeks ago.
The second component of an interest rate is the “real”, or inflation-adjusted rate. In general, the real component of interest rates should be positively correlated to the dollar. Just like any other asset, the value of the dollar is determined (in part) by supply and demand. As mentioned above, if the US economy is strengthening, the demand for dollars should increase as more money flows into the US and dollar-denominated assets to take advantage of the investment opportunities that normally accompany a booming economy.
In the chart below, we show that real interest rates track much more closely to the dollar than do nominal interest rates (which is the comparison in the chart above). You can easily see that over the past few weeks real interest rates have actually been trending higher, in line with the strengthening of the dollar. This makes more sense. Incidentally, I should also point out that when adjusting for inflation, the real rate of interest remains firmly in negative territory. This means that if you buy a 10-year Treasury bond today at a yield of about 1.5%, you will be losing purchasing power if you hold the bond until maturity. That’s not terribly attractive to me, but currency traders are less concerned with absolute levels than they are with how US rates compare to rates across the rest of the world.
What does it all mean? From where I sit, there are still two potential interpretations of the incoming market and economic data. The first is that the Fed is engineering a soft landing for the economy following an unprecedented burst in growth as the economy reopens. Under this scenario, the inflation we are now seeing will be transitory as it is being driven by temporary supply/demand dislocations as the economy reopens. Investors also may be placing a lower probability on a big infrastructure bill than they were a few weeks ago. This thesis would be supported by the recent strength in the dollar, rising real interest rates, and continued strength in the stock market.
The second, and still less likely, interpretation is that the economy is set for a dramatic slowdown or even recession within the next year or so. This is hard to imagine right now given the massive stimulus, the strength of the consumer, an accommodative Fed, recent strength in corporate earnings, and a world starting to emerge from the pandemic. However, this thesis would be supported by the rotation back into growth stocks (and out of value/cyclical stocks), the drop in market-based inflation expectations, the drop in commodity prices, and the slowdown in housing.
It’s fair to say that nobody can predict exactly how this economic reopening will play out. This is the reason that we prefer to own diversified portfolios of high quality stocks and bonds. The bonds provide some income and stability during uncertain times. The stocks offer portfolio growth at a reasonable price and a hedge against inflation. Blue-chip companies in growing industries typically have pricing power that offers investors some protection in an inflationary environment. As well, blue-chip companies with great balance sheets can endure recessions and gain further market share when the economy rebounds.
This is also the reason that we prefer to remain fully invested. Very few investors believed that March 23, 2020 would be the lowest point for the stock market. The pandemic had barely even started in the U.S.! Remember, emotion is the investor’s greatest foe. We are all human and prone to want to make emotional decisions that could be damaging to long-term returns. A disciplined investment process, such as that FMW employs, can protect our clients from emotional reactions.
Notwithstanding high valuations, the backdrop for stocks appears to remain constructive. The Fed can take a victory lap for now. But the high-wire act continues, and any evidence that the Fed could get spooked by incoming inflation data could be met with a market correction. Stay invested but nimble.