About a year ago we noted that the market was likely near—but not yet at—a turn in the U.S. dollar’s cycle. The U.S. currency’s inflation-adjusted, trade-weighted exchange rate has been slowly climbing through fits and starts since mid-2011. In a blog early last year, we noted that it had not reached its former cyclical peak of 2002 (Exhibit 1). But today we believe the dollar is fast approaching a new peak.
In short, we think the dollar rally is quite possibly in the midst of its last hurrah as the market finishes pricing in the likely series of interest rate hikes by the U.S. Federal Reserve (Fed) and the Trump administration’s new tax and trade policies, as details are released.
Our Global Debt Team remains prepared to reduce currency hedges and increase foreign-exchange exposure to our investment strategies should we feel the dollar has reached its peak. But in the meantime, we remain underweight foreign exchange and tactical in our positioning.
Our Views on Select Currencies
Although we are broadly underweight foreign exchange, we do see opportunities to seek benefits from long exposure to select currencies. We pursue tactical positions in currencies when valuations are attractive given the potential risks. Below are several examples.
- The euro (EUR): The U.S. dollar may rally temporarily against the euro, as the European Central Bank’s (ECB) bond-buying programs extend through the end of 2017. However, the euro’s fate may turn later this year—and perhaps as early as in the summer—as discussions begin about the potential reduction (or tapering) of its bond-buying programs. Such discussions should be supportive of the euro against the dollar. We think economic growth and inflation in Europe will be stable and strong enough for such tapering to be a high-probability event late in the year.
- The Brazilian real (BRL): The real’s positive carry1 alone is attractive when compared with most other currencies. An investor who bought a one-year, BRL-currency forward—assuming the spot exchange rate remains unchanged during that time—would make a profit of more than 8% (see Exhibit 2). Additionally, Brazil’s improving economic environment and fiscal condition suggest that the real should remain stable or appreciate against the U.S. dollar. Although Brazil’s central bank is likely to continue cutting interest rates, such monetary easing would be supportive of economic growth, which may give the real a boost after its long period of weakness throughout the country’s challenged economic and political environment of the past few years.
- The Indian rupee (INR): Structural reforms, capital inflows and lower inflation should remain supportive of the rupee. Buying it on a forward basis, though not as attractive as a similar transaction involving the Brazilian real, may result in a carry of more than 4.25%, with some cushion against volatility.
- The Turkish lira (TRY): Given Turkey’s turbulent political and economic environment, we maintain a cautious underweight position in the Turkish lira. While the lira may be fairly valued from a current-account perspective, we could tactically trade the currency if we see indications of conventional monetary policy returning. With many foreign investors shying away from the lira, this could provide some opportunities to buy the lira as large positive moves could occur as investors re-enter the market. However, we remain very cautious as we see local and external downside scenarios rather skewed, with potential downside moves more significant than the potential upside.
- The Taiwanese dollar (TWD): We are underweight the Taiwanese dollar on the basis of political risk we see stemming from a potential showdown between the United States and China over trade policy, which would likely affect the TWD. Additionally, Taiwan’s low interest rates make forward carry trades unappealing to consider (Exhibit 2).
The Potential Benefits of Active Currency Management
At the risk of being repetitive, we thought it important to reiterate the potential benefits of active currency management and hedging, given the risks and opportunities of international and global fixed-income portfolios denominated in non-U.S. currencies.
In last year’s blog, we featured Exhibit 3 (updated for 2016) highlighting that government bond returns can be significantly enhanced or hindered by currency performance. Hedging non-U.S. currency exposure over the past several years has benefitted international fixed income investors, but there have been long periods when long exposure to non-U.S. currencies greatly enhanced returns.
In either situation, we are proponents of active currency management, which, in our view, may help investors take advantage of opportunities across currency cycles – rather than allowing currency moves to be detrimental to otherwise attractive fixed-income returns.
Alpha is an investment’s return in excess of the return expected for the level of risk taken.
The Citi Non-U.S. World Government Bond Index is an index of fixed rate government bonds with a maturity of one year or longer and amounts outstanding of at least U.S. $25 million.
The Trade-Weighted U.S. Dollar Index (USDX, DXY) is an index (or measure) of the value of the United States dollar relative to a basket of foreign currencies, often referred to as a basket of U.S. trade partners’ currencies. It is a weighted geometric mean of the dollar’s value relative to other select currencies.
Indices are unmanaged and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict the performance of any Oppenheimer fund. Past performance does not guarantee future results.
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1Carry is defined as the profit investors gain from selling a certain currency with a relatively low interest rate and using the funds to purchase a different currency yielding a higher interest rate.