Hold onto your hat. The dollar surge, which started in April, looks set to continue next year.
The trade-weighted dollar index versus major currencies recently hit 95, having rallied from 88 at the end of April, according to data from the Federal Reserve Bank of St. Louis.
There are plenty of reasons to believe that the recent move is the start of something a lot bigger.
In the first place, there is the fact that the U.S. will have a new president, who has the backing of both the House of Representatives and the U.S. Senate. That means that the policies that the President-elect Donald Trump promised during the campaign stand at least a chance of getting implemented.
At the top of the list are big tax cuts and big spending.
The Trump administration. “Expansionary fiscal policy makes it more likely that the Fed will raise rates at a faster pace,” says Bill Adams, a senior international economist at The PNC Financial Services Group in Pittsburgh.
Trump has pledged to reform the tax code with lower corporate and individual taxes. On top of that he wants to implement a $1 trilllion infrastructure improvement program to fix the country’s ailing roads and bridges.
[See: 8 Ways to Profit From Donald Trump’s Infrastructure Plans.]
The consequence of that expansionary fiscal policy that Adams references is that not only will economic growth likely be higher, but so will inflation.
Enter the Fed. The Federal Reserve has a dual mandate. The first is to maintain full employment, which is pretty much where the economic metrics say the economy is currently. The unemployment rate sank to 4.6 percent in November, its lowest level since 2007.
The other part of the Fed’s mandate is to maintain price stability. That means that it must keep inflation neither too low nor too high. If the spending plans of the Trump administration do get implemented, then expect inflation to rise. That would likely result in the Fed being forced to raise the cost of borrowing aggressively.
The Federal Funds rate is currently at the historically low level of between 0.25 and 0.5 percent, so there is a lot of room for increases.
The good news is that when interest rates go higher foreign investors tend to want to buy dollars because they can then earn more money on their capital.
Central bank comparison. For investors, the focus is on what is the Fed doing versus what overseas central banks are doing, says Pravit Chintawongvanich, head derivatives strategist at Macro Risk Advisors in New York.
Or put in the simplest terms, if the Fed is increasing interest rates while other major central banks, such as the Bank of Japan or the European Central Bank, are keeping the cost of borrowing low then the dollar becomes a compelling buy for anyone who wants to grow their capital.
[See: 7 of the Best Bank Stocks to Buy in 2017.]
The compulsion to buy dollars becomes even greater when interest rates in other major currencies remain near zero or even negative.
Furthermore, the Bank of Japan seems intent on keeping its currency weak, at least for the foreseeable future.
The trend is your friend. When currencies move, the trend, up or down, can last a while. For the U.S. dollar it can be as long as a decade.
“The dollar bottomed in 2011,” says Michael Arone, chief investment strategist for State Street Global Advisor’s SPDR exchange-traded fund business. But these cycles can last seven to 10 years, he says.
That means we could be in for another five years of strength. How much more strength? That’s always hard to tell. What we do know historically is that the historical moves can be big.
For instance, the dollar rallied more than 50 percent against major currencies from June 1980 through February 1985. From 1995 to 2002, the rally saw gains in the dollar of around 40 percent, trough to peak.
So far, the dollar has rallied approximately 40 percent since the major low in 2011.
Investment implications. One way to play this trend is to invest in the PowerShares DB US Dollar Bullish exchange-traded fund (ticker: UUP). It is designed to track the performance of the U.S. dollar against six major currencies: the euro, Japanese yen, British pound, Canadian dollar, Swedish krona and Swiss franc.
It has annual expenses of 0.75 percent, or $75 for each $10,000 invested.
Foreign earnings headwind. Another investment implication is that the U.S.-based companies could see their overseas earnings decline as the dollar increases. Since close to half the earnings of the Standard & Poor’s 500 index comes from outside the U.S., a dollar rally could crimp profits.
If you want to remain positioned in U.S.-based stocks, then domestically focused companies (or those with little in the way of foreign sales) would be less hurt by a strong dollar.
[Read: How to Buy Stocks When the Dollar is Strong.]
In the same way, foreign-based multinationals may benefit from the increasing value of the profits that they make inside the U.S.
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Why the Dollar Will Surge Further in 2017 originally appeared on usnews.com
