THE IMPACT OF THE DOLLAR’S STRENGTH

The dollar has strengthened so much – and assuming it stabilizes at this level – that several regions may have to rework their macroeconomic approach as a result.

Compared to where it was in the first half of last year, the dollar is up 25%, as measured by the US Dollar Index. Earlier I wrote about the impact (bad and very bad) that this would have on those emerging countries that have dollar-denominated loans. This time I am more concerned with how the dollar’s strength will affect the larger economies.

Inflationary prospects for the US have already been negatively impacted by the fall in oil prices. Moreover, with what appears to be lasting strength, the dollar is expected to stay well under 2% for the upcoming one to two years, so it is quite easy to imagine there being no need to raise interest rates, perhaps for the entirety of 2015. This is an important change. A shock of this magnitude can have a negative effect on growth, but an even larger effect on profitability. It is almost certain that despite a growing American economy in 2015, there will be a drop in profits among the companies trading on the stock exchange. Furthermore, such a strengthening on the dollar could significantly slow GDP growth. There are all types of analyses that attempt to estimate its exact impact, and we can argue about their accurcy, but I am of the opinion that, thanks to the dollar, we will remain on the path that we are already on: American economic growth will remain stuck at 2-2.5%. So falling profits in the US, characterized by stable economic growth and low inflation for the next few months. This is not good news for stocks, but bonds do seem to be correctly priced.

A strong dollar, on the other hand, is an extremely positive development for Europe (or euro weakness, you can check the daily nominal effective exchange rate of the euro here, which has weakened 10% just in the past three months!). In the remainder of the year, we could see negative inflation, but from the end of 2015 into 2016, a quick jump up to around 2%, or beyond is possible. Deflationary worries are yesterday’s news; tomorrow’s is growth, and possibly the return of inflation. A weak euro has a very good effect on European growth prospects, and an even better one on company profits. It will come as no surprise if this year Europe sees outstanding growth, upwards of 3%, with double-digit profit growth, perhaps 20-30% even. It is no coincidence that European stocks are on the move…

Also of interest is what effect the strong dollar will have on China, where growth is drastically slowing. But since the yuan is for all intents and purposes tied to the dollar, additional strengthening puts the breaks on China further. Targeted growth of 7% seems to be out of reach; in the long run, 4-5% looks to be more realistic. Of course, the Chinese will do whatever it takes to curb the slowdown, but since they do not want credit expansion, they will be forced to act via changes to fiscal policy and yuan devaluation, or through lower interest rates: money will be cheaper in China, too. This is bullish for the stock market, which is incidentally still greatly undervalued.

Based on all of the above, it is entirely rational to take a position that assumes a reduction in in the difference between American and German long-term bond yields.

Riding on the coattails of a strong Europe, the Hungarian economic “miracle” could continue, which of course would not actually be a miracle, but we would cheer nonetheless.

You can find lots of estimates concerning the impact to currency fluctuations here.