Many global assets have fallen since last year, but the US dollar is not one of them. The greenback is up 15% year over year, and this rally shows no signs of letting up. And while it could end up bringing the global economy to its knees, we could take advantage of this investment opportunity. The dollar could be exactly the investment our portfolios need to help us through these times.
Why is the investment in the US dollar so strong?
Investing in the dollar is almost 30% stronger today than it was 10 years ago. The dollar index is up 15% over the past year, which tracks the value of the dollar against a basket of other currencies. Three factors have been behind the rally:
- Monetary policy divergence: The Federal Reserve (Fed) has been one of the most aggressive central banks in raising interest rates. With other large economies like Japan or the Eurozone having stimulative monetary policies, it has created a huge disparity in interest rates. This event has benefited investment in the USD.
- Economic weight: The US economy is one of the strongest in the world and by far the largest. Some of its companies are the most innovative, adaptable and fastest growing in the world. That led investors to favor U.S. stocks over those from other regions, generating strong inflows and a strengthening dollar.
- Safe Haven Flows: The dollar benefits when the US economy outperforms its peers. It also benefits when the economy is struggling. This is because US assets are perceived as safe and investors flock to them when the outlook turns dark. This amazing performance profile, this ability to perform well in both good times and terrible times, is known as the “dollar smile.”
Isn't high investment demand in the dollar usually good for the economy?
This is what it typically looks like. Strong investment demand in the dollar lowers import prices in the US, which is good for American consumers. At the same time, it makes foreign countries' exports more competitive and that boosts those economies. This explains why countries sometimes work to devalue their own currencies against the dollar.
Ranking of world currencies. Source: Expansion
Today we are in an almost opposite situation, which is why some people talk about the threat of "reverse currency wars." The biggest risk to economies now is not slow growth, it is high inflation. For today's economies, a stronger national currency is preferable. Basically because it reduces the price of investment in imports and helps offset part of that inflation.
So, is high investment demand in the dollar a risk?
The high investment demand in the dollar has actually been posing a serious threat to the global economy. As inflationary pressures rise abroad, it has forced foreign central banks to raise interest rates. Sometimes aggressively, and that will likely worsen the growth pressures already present. At the same time, a rising dollar investment demand has a massive impact on global financial conditions. Most companies and governments, especially in emerging markets, borrow in dollars. When the dollar rises, its financing cost rises. And that puts pressure not only on your current financial situation, it also slows down credit creation, which will also reduce future growth.
Variation in the value of different currencies of emerging countries during 2022. Source: Statista
Put another way, upward dollar reversal is akin to global quantitative tightening. It's bad for global growth and for almost every asset out there. Some major economic crises have coincided with times like these, when the Federal Reserve raises interest rates and the dollar rises. The Latin American debt crisis of the early 80s was one, and the Asian and Russian crises of the late 90s were two more.
When will investment in the US dollar weaken?
Investment in the US dollar will begin to weaken as the disparity in key interest rates between the US and the rest of the world narrows. Now, if the Fed took its foot off the rate-hiking pedal, it would lower the upward pressure on U.S. interest rates and allow other economies to breathe. If other economies set higher rates without entering a full-blown recession, global growth may resume. At that point, investment can flow from the US into global markets, weakening the dollar in the process.
The countries most at risk from the rise of the US dollar. Source: Business Insider
That doesn't seem particularly likely in the short term, because the US is fighting sky-high inflation and needs higher interest rates and a strong currency to win that battle. The only reason the Fed would be less aggressive with rate hikes would be the US economy dragged down by inflation. However, in that scenario, the world is also likely to succumb to recession. Investment sentiment would drive safe-haven flows into US assets, keeping the dollar high. Unless an extreme event occurs, the dollar is likely to remain strong at least until inflation. Investors' worries disappear.
So what investment do we make to protect our?
An investment in the rising dollar is a major source of risk for the global economy. But it can be a source of strength for our portfolio. By going long the US dollar, you would hedge the risk of a sharp drop in global growth. It would also protect our portfolio from the risk of the Fed becoming even more aggressive with its rate hikes. This could happen if inflation turns out to be even stiffer than expected. In that scenario, a long investment in the USD may be the only position that could save our portfolio. Both bonds and stocks would likely be affected. And if the dollar weakens, it's probably a pretty good environment to make a good investment. In turn, the rest of our portfolio should perform well. We can make an investment in US dollars through the Invesco DB US Dollar Index Bullish Fund (UUP). The more defensive we want our investment in dollars to be, the more risky the investment will be in currencies that we should sell against. Going long the US dollar against the Canadian dollar, Australian dollar or New Zealand dollar would be good options in that case.
If we want to benefit from the possible weakness of the US dollar by remaining on the defensive, the Japanese yen is a good investment; It is trading at attractive levels and appears to be on the verge of recovery. How we argue here above, the yen should be the main beneficiary in case the rise in the dollar proves disruptive. We can make an investment directly against the US dollar through Invesco Currencyshares Japanese Yen Trust (FXY).