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The Federal Reserve’s F/X Paradox

Talk is Never Cheap for the Federal Reserve

The Fed is facing a market conundrum.

Again.

After 6 years of unprecedentedly low interest rates that helped pull the U.S. out of the recession and have carried stocks to new highs, the Fed said 2015 was the year they would raise rates again.

But first the Fed needed to see:

  • Consistent annual GDP growth of around 2.5%
  • Gradual increases in inflation
  • Continued declines in the unemployment rate

Unfortunately, it seems that the recently strengthened dollar is throwing a monkey wrench into the Fed’s plan. 

The WSJ Dollar Index (shown above) measures the U.S. dollar against a basket of major currencies.
The WSJ Dollar Index (shown above) measures the U.S. dollar against a basket of major currencies.

The dollar is up about 20% over the last year and has gained 13% in just the past 6 months alone.

A stronger currency tends to undermine exports because it makes them more expensive. That slows growth and potentially hiring. Meanwhile, the strong currency holds down the prices of imports and broader inflation.

In other words: lower GDP, low inflation, and less hiring.

Cheap Talk and the Fed’s Paradox

It’s easy to blame the currency for the economic softening here but the real underlying cause for the stronger dollar is the market, and the market’s weird reaction to the Fed’s forward guidance.

Forward guidance is the verbal assurances from the Fed to the public about its intended monetary policies (namely letting investors know what to expect from interest rates).

The point of forward guidance is to keep the economy stable as interest rates rise. But it also has been undermining that plan.

Fed officials have been signaling since last year that they expected to raise rates in 2015 because they forecast the economy would continue strengthening. Consequently, investors anticipating that move have plowed funds into U.S. dollar assets in search of higher returns, pushing up the value of the currency and contributing to the economic slowdown officials now confront.

This same thing happened about 2 years ago, when the Fed’s plan to end QE3 resulted in the market’s “taper tantrum” that sent Treasury yields up.

The paradox here is that the closer the Fed gets to increasing interest rates, the more investors will buy U.S. dollar-denominated assets expecting higher future returns, causing the U.S. currency to appreciate. But the more the U.S. dollar appreciates, the further the Fed gets from ever increasing interest rates, starting the whole cycle over again.

Guessing Game

What This Means for Value Investors

The market was preparing for a June rate increase, but now it’s unlikely that will happen by September, let alone June.

So the whole cycle will continue and the strong dollar will likely remain strong – especially with zero or even negative interest rates in many other countries around the world.

This strong dollar, in turn, will continue to eat into the profits of large multinational U.S. companies who have a large amount of exports or who have substantial operations abroad. In the short-term, Wall Street – which is overly focused on quarterly and recent earnings – will penalize stocks of these companies.

This could open up some buying opportunities for value investors who are oriented for the long-term.

After this earnings cycle and the next, expect to see stocks of many large blue-chip companies continue to underperform the broader market. Also expect many articles and “pundits” detailing the struggles of these companies, claiming that these old giants can no longer compete in this economy of the future.

Some will live up to those claims.

Some will be buying opportunities.