Fish in the ocean probably don’t have a sense that they’re underwater, just as we don’t think much about being surrounded by air all the time here on the surface of earth. Nevertheless, those environments are critical to everyday life for fish and people, even if they are easy to ignore.
Similarly, everything we do economically is tied to the U.S. dollar, and it’s easy to forget how important it is to our daily lives. Americans have to think even less about other currencies than most global citizens because oil and a great deal of international trade is priced in dollars. Nevertheless, the U.S. dollar is not a fixed measure but fluctuates in value frequently — against other currencies, commodities, and anything else priced on a large scale worldwide.
The best-known index of the dollar’s value is the DXY index, which compares the dollar against six other major currencies. According to the DXY index, the dollar has appreciated by about 30 percent over the last ten years and is up 10 percent this year alone. A strong dollar might seem like a good thing, and it does make imported goods cheaper and international vacations more affordable. However, dollar strength can create problems throughout the world, including here in the U.S.
When the dollar rises, exports from the U.S. are less affordable, which hurts U.S. businesses. The price of oil becomes less affordable for the world, as global oil trade is still almost always priced in dollars. This makes goods more expensive even in the U.S., since oil is critical to almost every aspect of production and transportation in global trade. Smaller countries feel even more pain, since they often issue dollar-denominated bonds, which become more expensive to service and ultimately pay off.
Several phenomena can cause dollar strength. The demand for the dollar is uniquely strong, since it is required to settle so many sorts of international payments throughout the world. Also, when geopolitical tension rises, investors tend to buy up dollars and U.S. treasuries as a safer place to park money. But perhaps most importantly, demand for the dollar is driven by interest rate differentials, since currency traders prefer holding currencies that generate the most “carry,” or net interest on investment in the currency.
The Fed has quickly and consistently hiked interest rates in 2022, and the carry created by these rising interest rates means that demand for the dollar went even higher this year. The Fed’s actions pushed USD up almost 20 percent at one point in 2022 alone, which is a startling move for an asset class that is typically much less volatile.
The natural swing of the dollar up and down over time suggests you probably want some exposure to non-dollar assets like international stocks at all times. If the status of the dollar as the reserve currency or treasuries as the reserve asset is meaningfully challenged then non-dollar assets can do some real work in your portfolio.
The dollar was up 20 percent in 2022, but since the peak it has fallen about 10 percent on expectations the Fed will pause or cut rates in the future (reducing the carry). As one consequence of this, the international indexes we follow are dramatically outperforming U.S. markets in Q4 of this year.
Fish may not be able to diversify out of water and we can’t diversify away from air, but we can definitely diversify our investments. As Nobel Laureate Harry Markowitz once said, diversification is the only free lunch, and it’s likely that international exposure could be increasingly important to your secure financial future in the years to come.
Gene Gard CFA, CFP, CFT-I, is Chief Investment Officer at Telarray, a Memphis-based wealth management firm that helps families navigate investment, tax, estate, and retirement decisions. Ask him your questions or schedule an objective, no-pressure portfolio review at letstalk@telarrayadvisors.com. Sign up for their next free online seminar on the Events tab at telarrayadvisors.com.
