With the dollar strengthening over the last few weeks, we will use today’s “Data” section to discuss the greenback and the related topic of interest rate differentials between US Treasuries and other developed economy sovereign yields. We will also touch on what all this means for US stock prices, of course.
Here is a chart of the Fed’s Nominal Dollar Index back to 2006. We’ve highlighted how the dollar traded after the Financial Crisis (peak dollar in March 2009) and the Pandemic Crisis (peak dollar March 2020). In both cases, the dollar declined once capital markets started to recover. From 2009 – 2011 it fell by 19 percent, albeit with a countertrend rally about halfway through the move. Since the dollar’s peak in March 2020, the dollar has declined in value by 9 percent over the last 20 months.
The upshot here is that the dollar has held in better in 2020 – 2021 than the post-Financial Crisis experience, falling by only about half as much (9 pct vs. 19 pct). That’s not especially good news. You want to see the dollar decline after a crisis as a sign that investors are moving capital out of safe haven assets and into riskier ones. We’ve gotten some of that move, true, but not as much as post-2009. Moreover, if the post-2009 experience is any guide, then the dollar’s weakening phase in the early stages of a global economic recovery is all but over.
Now, the sharp-eyed reader will look at the chart above and say “Hey … What about that step function increase in the dollar’s value from 2014 – 2017 and how the greenback has generally held up so well since?” That is a good point, and one at odds with the all-too-common narrative that the dollar is on its last legs.
The chart below shows the difference in yields between 10-year Treasuries and Japanese government bonds (red), German bunds (black) and UK gilts (purple) over the same timeframe as the dollar graph above (2006 – present). As you can see, Treasury yields relative to other developed economy sovereign debt generally rose from 2014 to 2019. The differentials peaked in 2019 at 1-3 points but remain fairly wide (0.5 to almost 2.0 points) even today.
Now, we’re not saying that the dollar is holding up because global capital is seeking out the highest yield among developed economy sovereign paper (which would be in Treasuries). There are currency hedges to consider, which in many cases eliminate notional yield arbitrage.
Rather, we see dollar strength and higher Treasury yields than in the UK, Germany, and Japan as indicative of the market’s incremental confidence in the future of the US economy and capital markets. That might sound strange. But … Consider that US fiscal and monetary policy was much more accommodative over the last 18 months than in Germany, Japan or the UK, and America’s future demographic growth is better as well. Also, while inflation is a problem all over the world, markets are confident that the Federal Reserve will address this issue next year. Will the ECB taper and raise rates in 2022, or the JGB for that matter? We tend to doubt it, if only because Europe and Japan have had structural growth problems for a long time.
If the dollar does rally from here, what does that mean for US stocks? The recent round of dollar strength has caused some concerns on this point. A stronger greenback means offshore profits face a headwind for financial reporting purposes, after all.
The historical record says not to worry, however. As the first chart shows, the dollar rallied almost nonstop from 2012 – 2017. Over that same period, the S&P 500 more than doubled (+140 percent). Earnings growth of 65 percent drove about half that move. The rest came from the decade’s rally in US Big Tech and modestly lower long-term bond yields.
Takeaway: the 2009 – 2011 post-crisis playbook says the dollar should still be weakening, but markets seem to be skipping that step and moving on. That’s OK, at least as far as US equities go. A stronger dollar and still-wide spreads between Treasuries and other sovereign debt are signs that future growth should be stronger than other regions.