Why currency matters – what the strong US dollar means for you
There is no doubt over which asset class has performed best in this troubled year – the mighty US dollar.
The world's reserve currency has confirmed its supreme safe haven status, putting pretenders such as the Swiss franc and Japanese yen to shame.
At time of writing, the greenback is up almost 5 per cent against the Swiss franc year-to-date, and a stunning 15 per cent against the yen.
It has also hammered the euro, which has fallen almost 12 per cent this year to parity, so a dollar buys almost a whole euro. A year ago, it bought just €0.85.
The US dollar has proven a better store of value than gold, as well as Bitcoin, making fools of those who claimed it was “digital gold”.
Yet investing is cyclical, and winners can quickly turn into losers. Dollar strength has been driven by weakness everywhere else, as inflation rockets, war rages in Ukraine and recession fears rise.
What happens when confidence returns, as it will at some point?
At that point, the only way for the dollar is down.
Weak outlook, strong dollar
The dollar has been in demand because it offers investors a safe port in an economic or political storm, Alex Harvey, senior portfolio manager & investment strategist at MGIM, says. “Its global reserve status, and the US government that stands behind it, offer sanctuary at times of capital flight.”
Investors are also buying US government bonds in search of higher yields, as the Federal Reserve turns hawkish and hikes interest rates to curb inflation. In July, the Fed lifted the fed funds by 0.75 per cent to a range of 2.25 per cent and 2.50 per cent, and two more rate hikes are expected this year.
Last summer, 10-year US Treasuries yielded 1.21 per cent. In mid-June, yields peaked at around 3.48 per cent, giving investors triple the income.
Currency swings can be a “boon or bane” for investors, depending on what you own and where you own it, Mr Harvey says.
So far this year, it has been a boon for many overseas investors.
When the S&P 500 dipped into bear market territory, investors in currencies such as euros in pounds were cushioned as dollar strength mitigated their losses.
Gold is priced in dollars and while the price has barely moved it is up 8.5 per cent in euro terms to around €1,743.
So what happens if the dollar falls?
The US dollar may now have peaked
Nothing goes up forever, certainly not currencies. They do not have an intrinsic value of their own, but rise and fall relative to rival currencies.
These fluctuations can be dramatic over the short term, says Jean-Yves Chereau, partner at investment manager J. Stern & Co. “Yet over the long-term, currencies tend to revert back to the mean.”
With the US dollar now trading at a 24-year high against the yen and a 20-year high against the euro, the descent could be dizzying. It may have already begun.
Markets are betting the Fed will slow the pace of rate hikes to avoid tipping the US economy into a deep recession. Next year, it could even start cutting rates again.
Yields on 10-year Treasuries have now slipped to around 2.71 per cent as markets look forward to a more dovish Fed.
So what should you do?
You could protect yourself by hedging
Every international investor should check their exposure to foreign exchange swings. If you spend in one currency but your assets are denominated in another, you are in danger. It becomes a burning issue as you near retirement and start drawing money from your investment portfolio.
The big danger is that a currency and stock market falls at the same time. When this happens, it may double down on your losses.
If you feel exposed to currency movements, some active managers and exchange traded funds (ETFs) offer versions that hedge foreign currency exposure back into your home currency, to neutralise the impact.
Typically, they invest in the same portfolio of conventional assets but use derivatives to offset the effect of currency movements.
Their fees tend to be slightly higher as a result, typically around 0.03 per cent more, so it is worth checking.
They might for example say with “Hedged EUR or “Hedged GBP” at the end, depending on the currency.
They shouldn’t be confused with funds that are simply priced in different currencies, depending on the jurisdiction they are sold in.
Nor should they be confused with hedge funds.
Many private investors use them with bonds, Mr Harvey says, where currency risk can swamp the overall returns. “It is not unusual for bond holdings to be hedged, to isolate the underlying bond returns.”
There may be an easier way.
Focus on the underlying fundamentals
Hedging against currency fluctuations is complex, Mr Chereau says. “This is particularly true for private investors, who have less access to professional information and the tools to hedge a position.”
Also, the interplay between currency and stock market performance is complex. A strong currency often weighs on equities, by making exports more expensive to overseas buyers, which may hit demand, sales and company profits. Japanese equities, with a large exporting base, have been buoyed this year in part due to the yen’s weakness.
Similarly, sterling weakness has boosted London’s blue-chip FTSE 100 index, which has held firm this year when most rivals have crashed.
Companies listed on the index generate almost three quarters of their earnings overseas, so the pound’s weakness boosts the relative value of their overseas earnings.
M large international companies generate revenues in a mix of currencies, giving you a natural hedge.
As ever, stay diversified
Currency impact is complicated. Most private investors ignore it, and hope things pan out over time.
This may not be the worst strategy, either. Trying to time the market is difficult at the best of times, and the same applies to currency markets, as well.
For investors investing in a basket or fund of global stocks, earning international revenues, fluctuations tend to even out over time.
Mr Chereau says it is more important to focus on buying quality stocks with strong products and brands, pricing power and ability to defend itself against competitors. “This should all translate into revenues, earnings, cash flow growth and ultimately share price performance,” he adds.
This does not mean you should simply ignore currency risk, especially if retired.
Yet if you retain a globally diversified portfolio, the ups and downs should cancel each other out over time.
So enjoy the benefits from this year’s dollar strength, but remember it will not last. Dollar weakness will bring benefits, too.
A properly balanced portfolio should be ready whatever happens.
Harvey Jones has been a UK financial journalist for more than 30 years, writing regularly for a host of UK titles including The Times, Sunday Times, The Independent and Financial Times. He is currently the personal finance editor of the Daily Express and Sunday Express, and writes regularly for The Observer and Guardian Unlimited, Motley Fool and Reader’s Digest.
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Please note the value of investments can go down as well as up, and you may not get back all the money that you invest. Past performance is no guarantee of future results.