A Strong Dollar: the Good, the Bad, and Potentially Ugly

For which of you, intending to build a tower, sitteth not down first, and counteth the cost, whether he have sufficient to finish it?

Luke 14:28

I have been critical of the Federal Reserve for many years – including being vocal in this newsletter for at least the last two years. Few would venture to debate the fact the Federal Reserve board or “Fed” has been wrong on inflation – both underestimating the magnitude of the problem as well as slow to raise rates. However, the Fed has caught religion recently and have raised rates quickly this year in an effort to permanently crush inflation.

To understand the extent rates have increased this year consider: the one-year treasury started the year yielding .38 percent. As of this writing it yields ~4.5 percent! That is an unprecedented, enormous move in less than one year! While the Fed has been slow – Europe and Japan have been even slower and as a result our rates went up much more quickly. Our higher rates compared to these other countries has made the US Dollar more attractive to investors across the globe – with the dollar surging from 10-30 percent compared to a basket of other world currencies.

Big moves such as this have significant impacts on a wide range of financial markets – effecting companies, countries, and families not just in the United States but throughout the world.

The “Good” of a strong US Dollar:

much more attractive short term bond yields – with a ripple affect on money market rates as well as CD’s
The dollar buys much more foreign goods than it did even very recently
It is much cheaper to travel abroad for US citizens as strong dollars buy more in Europe, Japan and other countries than they have in decades
Lower prices of foreign goods and services competing against US firms and a deflationary impact

The “Bad” of a strong US Dollar:

Commodities including food and oil are generally priced in dollars on the world market. A strong dollar makes these more expensive – not only to strong economies abroad but also poor third world countries and their citizens
Large US-based multi-national companies’ products and services are more expensive to foreign buyers
Most foreign debt is denominated in dollars – meaning emerging market economies need to pay back their debts in “expensive” dollars.
Foreigners traveling in the US becomes more expensive

The “Potentially Ugly” of a strong US Dollar:

I love this quote from Art Cashin: “Don’t bet on the end of the world, it only happens once”…

So don’t bet on a Black Swan event – by definition they are impossible to predict. But, large moves like the changes in the relative values of currencies of global superpowers (UK Pound compared to US Dollar) have far reaching consequences that sometime take a while to reveal themselves.
In the case of Long Term Capital Management in 1998 moves of generally very stable assets (like currencies) sometimes go in the opposite direction their quantitative models predicted – causing carnage on positions with a high level of leverage.
Volatility of typically stable assets (mortgage loans and derivative insurance of those loans) was also the primary reason for the demise of two Bear Stearns hedge funds in 2007 which ultimately led to the collapse of Lehman Brothers and the Great Recession.

Your take-away’s from this newsletter?

A strong dollar is neither good nor bad intrinsically.
Don’t invest in highly leveraged investments. Debt requires debt service – which results in bankruptcy if not paid.
There's a real risk that recent volatility in currencies which are broadly owned and traditionally stable will wreak havoc on financial markets and destabilize countries with weak economies.
Stocks can be volatile – but in the aggregate have never gone to zero. Rather than "renting" stocks - buy and own more small, profitable companies with little or no debt. They are more likely to not only survive but thrive in a strong dollar economy. They also have the highest historical returns.