It shocked some people that the U.S. dollar has showed so much strength as of late. But if you were using logic and ignoring all the chatter, you would have seen it coming. That said, all that matters now is the future. Currently, many investors and pundits are calling the dollar a crowded trade. But its rise is probably just getting started. (For more, see: 3 Factors That Drive the U.S. Dollar).
The first thing dollar bears will point out is that rallies in 1974, 1989, 1991, 1993, 2008 and 2010 didn’t last. And they’re even more likely to point out that the huge bull run in the early 1980s also wasn’t sustainable. Using historical trends to help dictate future results is often a good idea but there’s one major difference at play here: not one of the times listed above was deflationary.
When deflation occurs (due to reduced demand), products for goods and services come down making each dollar more valuable because it can buy more. With the value of every dollar increasing, debt becomes more expensive. While the price for that new smartphone you want might come down, the cost of your debt remains the same. Therefore, people hurry to pay off their debts not wanting to have the extra burden. Governments will also pay off debt. This has a much bigger impact on the value on the dollar. If debts are paid off then there are fewer dollars in the system, which makes the dollar more valuable.
Then you have to take into account the possibility of the Federal Reserve raising interest rates. When this happens, the value of the dollar increases. It is still possible for the Federal Reserve to become dovish, which would negatively impact the value of the dollar but this isn’t a likely scenario. And you can’t rule out another possibility which is that the raising of interest rates will be a buy-the-rumor/sell-the-news event. However, even if this is the case, a decline in the dollar and the exchange-traded fund (ETF) that tracks it, the PowerShares ETF Shs DB US Dollar Index Bullish Fund (UUP) shouldn’t last long. (For more, see: Trade Market Volatility with These ETFs).
UUP tracks the performance of the dollar against the euro, Japanese yen, British pound, Canadian dollar, Swedish krona and Swiss franc. It was just determined by the European Court of Justice that the European Central Bank’s (ECB) bond-buying program will be seen as legal. That being the case, the ECB is likely to implement its own quantitative easing (QE) program. The euro is already trading at a nine year low against the dollar and this isn’t going to help matters much. This is on top of Switzerland abandoning its link to the euro. You also have to take into account Japan, which continues its relentless pursuit of monetary stimulus to combat its own deflation, which relates to an aging population that doesn’t consume as much as younger generations. (For more, see: Will the ECB’s Quantitative Easing Sink the Euro?).
This is all positive for UUP. However, if you want to see the global economy grow and the world remain intact then you might not want the U.S. dollar to continue its relentless ascent. The biggest threat is that since emerging markets acquired their debts in U.S. dollars, those debts will become more difficult to pay off. This could end up spreading back to the U.S. economy.
As far as stocks go, they don’t perform well in deflationary environments. The dollar should remain strong if there is any type of correction in equities. Some feel deflation is good for the consumer, which is then good for stocks, but that’s only the case for the short term. When deflation strikes, people horde their money to wait for better prices — since prices keep going lower — which isn’t a positive for U.S. stocks, especially in technology and consumer goods.
Fortunately, deflation is a necessary evil. Paying off debts and growing organically again is the correct path to sustainable prosperity, even if it means years of sacrifice and economic pain. (For more, see: How Countries Deal with Debt).
The Bottom Line
While no investment is a guarantee, for the next year and potentially the next several years, the U.S. dollar appears to be one of the safest investments out there. It could be a crowded trade, but it’s still a small crowd that has the potential to grow. And the trend is always your friend. Remember how investors thought the rise in equities would end in 2009, 2010, 2011, 2012, 2013 and 2014? UUP comes with an expense ratio of 0.82% but that shouldn’t deter any interested parties from considering an investment.
Dan Moskowitz does not own any shares in UUP.