A lot has transpired in the currency markets over the last several weeks as developed countries race to see who can have the lowest interest rate on their sovereign debt (Japan seems to be in the lead). Also affecting the value of currencies is economic data from Europe, Asia and the U.S., which is mixed and suggest that global economic growth will continue to be positive but slow. There are some messages in the currency tea leaves that we can read and use to determine how our asset allocation strategy may be affected.
In order to understand why the value of currency matters, it might help to take a moment to discuss how the value is determined in the first place. The value of a country’s currency represents the equilibrium exchange rate at which its external position, i.e. the balance between exports and imports, is equal. Of course it isn’t really ever equal; let’s face it; this is economics theory which never fully represents the real world.
However, we can understand from this theory that the lower the value a country’s currency goes, relative to its trading partners, the more attractive their goods and services become for export. When a country’s exchange rate is too low, it tends to export too much and build up excess foreign reserves. Other countries might suggest that this exchange rate is artificially low and should be raised in order to create more balance. Think about the discussion a couple of years ago, on Capitol Hill, when Congress was suggesting that China needed to allow its currency to move higher. Of course, now that China’s growth rate has subsided and jobs are actually moving out of the country, this has stopped.
A country like China exports more than it imports, especially when consumer demand remains low relative to the attractiveness of goods and services being sold abroad. As the Chinese consumer has become more robust, their economy will rely less on exports and more on consumption. If they don’t allow their currency to move higher, then consumers will be paying more for foreign goods, which dampens demand.
This trade-off goes on in every economy. The stronger consumer demand, the more likely the currency exchange rate improves because a cheap currency isn’t necessary to attract foreign capital and stimulate demand. A strong economy in the U.S. means a stronger consumer because they represent over 70 percent of our economy. When consumer demand strengthens, concerns about inflation rise and central bankers tend to want to raise interest rates to prevent it from rising too quickly. In this way, interest rates and currency value is linked.
The value of the Euro has declined by 4 percent vs. the dollar in the last month. As evidence continues to pile up that Europe’s economy is very sluggish and consumer demand weak, the European Central Bank (ECB) has lowered interest rates to try to stimulate demand. They believe that a lower interest cost should get companies and consumers borrowing money again. This hasn’t worked and demand remains very weak. Much of Europe won’t even see a 1 percent economic growth rate for the year. At the same time, the ECB recognizes that the economic engine of Germany, the largest country in the Euro-Zone, is an export-driven economy. A lower currency exchange rate should make their goods more attractive. In Europe, we see more accommodative interest rate policy, a weaker economy and slack consumer demand.
Contrast that with the U.S., where we see some improvement in economic activity, an uptick in consumption (a recent retail sales report showed that sales are up over 6 percent in the last 12 months) and a central bank that is reducing their stimulative policy. As the Fed further reduces bond purchases, we will see a stronger dollar relative to both European and Asian developed market currencies. Markets are looking for any indication that the short-term Fed funds rate will rise more quickly than late 2015. At the same time, demand for Treasuries and low interest rates abroad have held longer dated Treasury yields down.
The U.S. 10-year Treasury yields 2.38 percent, .6 percent lower than the beginning of the year, while the 2-year now yields 0.56 percent, almost double what it was at the beginning of the year. The German 10-year Bund is trading at a yield of 1.08 percent and even Spain trades below the U.S. at 2.33 percent. In Japan the yield is 0.57 percent. In the U.S., we may continue to see short rates move higher while longer rates remain relatively stable.
The stronger dollar also affects commodity prices, which have declined recently. Oil, as an example, trades in dollars. When the dollar strengthens, the price of oil declines in order to maintain equilibrium with the supply/demand trade-off in global oil markets.
For our part, we monitor the affect currency has on asset prices globally. The challenges facing central banks around the world create asset price opportunity. We hire investment managers that utilize strategies that attempt to take advantage of currency price dislocation. In addition, we understand that global economic growth has an impact on asset prices as well and that not all economies are created equal. We believe the managers we hire are skilled in assessing the value of currency in equilibrium, gauging the impact of global geo-political events and making investment decisions using this information. Our investment opportunity set is global and so we deploy capital in that manner.
The buck stops here when it comes to accountability for achieving our clients’ desired outcomes.
Brian K. Andrew, CFA, is president and chief investment officer at Cleary Gull Inc., an investment advisory firm in Milwaukee. He leads the firm’s investment research and strategy and chairs the Investment Policy Committee.