A Strong U.S. Dollar Changes Everything A white paper by Kathy A. Jones, Senior Vice President, Chief Fixed Income Strategist

Schwab Center for Financial Research

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The U.S. dollar is near its highest level since 2003. We think

the dollar has entered a longer-term uptrend that could

continue. Factors behind the dollar’s advance include the

improving U.S. economic growth prospects relative to other

major countries and the shrinking U.S. trade gap. Also, the

monetary policies of the U.S. Federal Reserve and other

central banks are moving in opposite directions. Foreign

central banks have adopted policies to stimulate their

economies while the Fed is shifting toward tightening policy.

The strengthening dollar has important implications for

investors. In this wide-ranging interview, Kathy Jones shares

her investing outlook on the U.S. dollar and its effects on the

fixed income market.

Kathy A. Jones

Senior Vice President,

Chief Fixed Income Strategist

Schwab Center for Financial Research

Kathy A. Jones is responsible for credit

market and interest rate analysis, as well

as fixed income education for investors at

Schwab. Jones has studied global credit

markets extensively throughout her career

as a fixed income investment strategist,

working with both institutional and retail

clients.

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Executive Summary

• The U.S. dollar has appreciated by more than 20% on a trade-weighted basis since last year. We believe the dollar is going to continue to move up longer-term.

• Improving U.S. economic growth, the diverging trend between U.S. monetary policy and the policies of other central banks as well as the declining U.S. current account deficit are factors driving the dollar higher.

• A stronger dollar has important investment implications. We suggest reducing exposure to international developed-country bonds and emerging market bonds and commodities.

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Could you describe the drivers for this idea?

There are many factors that influence the direction of a currency. In a free-

floating currency system, demand for a currency is often driven by relative

economic strength, interest rate differentials and trade performance. Strong

economic growth usually means higher returns on investment and higher real

interest rates, which tend to make a currency attractive to hold. A country with

a trade and/or current account surplus will tend to have a stronger currency

than one with a deficit, all else being equal, because demand for the currency

will rise along with its surpluses. And since economic trends are often longer-

term in nature, currency trends can last for years at a time. A final factor is

more difficult to quantify – the perceived safety of holding the currency.

When was the last time the U.S. dollar experienced a long-term surge?

The U.S. dollar has seen two major bull markets in the post-Bretton Woods

era, which began in 1971 when the dollar’s ties to gold were severed. Each bull

market lasted for about six years. The first, from 1979 to 1985, saw the dollar

nearly double in value. A key driver in that bull market was high U.S. real

interest rates. The Federal Reserve was fighting inflation and U.S. interest

rates soared, attracting foreign capital to the U.S. markets. The bull market

ended when an agreement between the world’s major trading partners – the

Plaza Accord – was reached to bring the dollar back down.

The second major bull market, from 1995 to 2001, was driven in large part by

the technology boom in the U.S., which boosted economic growth and drew in

foreign investment to U.S. markets. When the tech bubble burst, the stock

market declined, interest rates dropped and foreign investment slowed, leading

to a weaker dollar.

A key factor behind the

dollar’s recent strength

is the U.S. economy’s

performance

compared with other

major countries.

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Why are you bullish on the U.S. dollar now?

In our opinion, a key driver behind the dollar’s recent strength is the

performance of the U.S. economy compared with other major countries. Over

the past year, the U.S. economy appears to be on firmer footing, while growth

remains slow elsewhere. The IMF estimates that the U.S. economy will expand

at a 3.0% pace in 2015 compared with 1.5% for the Eurozone and 1.0% for

Japan. Emerging market countries are also slowing down. The IMF estimates

GDP growth among this group to be 3% this year the lowest since the financial

crisis.

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With relatively stronger growth, U.S. interest rates – even at current paltry

levels – are significantly higher than those in core European countries or Japan,

making the dollar more attractive for investors to hold. Germany’s interest

rates are actually negative while Japan’s are stuck near zero. Even among the

other major developed countries, such as Canada and Australia, interest rates

are falling and look likely to remain low due to the slowdown in global economic

growth and falling commodity prices. Central banks in Europe and Japan are in

the midst of large quantitative easing programs to boost economic growth

which has depressed interest rates. China’s slowdown is weighing on the

currencies of countries with which it trades.

Wide interest rate differentials are often a key driver of currencies. Higher

interest rates make a currency attractive to hold for investors and difficult to

short among traders. For example, the trend in the euro/dollar recently has

tracked very closely with the short-term interest rate differential between the

U.S. and Germany, Europe’s largest economy.

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You mentioned that emerging market countries are experiencing slower growth. How does this affect the dollar’s valuation?

In recent years, emerging market countries have played an increasingly

important role in the dollar’s valuation. EM countries have expanded their

share of GDP and global trade, making them a bigger force in the currency

markets. And since the Asian currency crisis in the 1990s, many more EM

currencies are free-floating rather than pegged to the dollar. But slower growth

in EM countries recently has weighed on those currencies versus the dollar as

well. To a large extent, the slowdown in China’s growth is a contributing factor

to the weakness in other EM currencies and some dollar-bloc currencies due to

their close trade ties. Countries that export raw materials to China such as

Brazil and Australia have seen their currencies fall steeply in the wake of

China’s slowing growth. The chart below shows the trend in the dollar versus an

index of mostly EM countries – described as “other important trading partners”.

Slowdown in China’s

growth weighs on other

EM currencies.

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Can you explain the different paths the U.S. and other countries are taking with their respective monetary policies?

The divergence in growth prospects between the U.S. and much of the rest of

the world has global monetary policies heading in opposite directions. The U.S.

Federal Reserve has ended its bond-buying (quantitative easing) and is aiming

to raise interest rates perhaps sometime in 2015, although those plans are not

carved in stone. In contrast, other central banks are likely to keep short-term

interest rates low or even negative and have pursued expansive monetary

policies to boost growth.

Europe’s central bank plans to expand the bank’s balance sheet by as much as

1 trillion euros by September 2016. In Japan, the central bank’s balance sheet

is already at 60% of GDP and rising, while the U.S. Federal Reserve’s balance

sheet is at 25% of GDP. The UK is the only other major central bank to have

considered tighter monetary policy, but with inflation falling steeply it’s likely

that those plans will be postponed.

Is international trade an area of concern for the dollar’s strength with global economic growth slowing?

The U.S. is less dependent on exports to fuel growth than most other major

economies, which helps when growth outside the U.S. is slowing. Exports only

account for about 13% of overall GDP in the U.S., compared to 25% to 55% for

most other major G-7 countries. Since the U.S. runs a trade deficit it needs to

attract foreign capital because the balance of trade by definition has to

balance. Over the past few years, the boom in domestic oil production has

helped reduce the U.S. trade deficit. The U.S. current account deficit, which

includes trade and net earnings on foreign investments, has been shrinking

relative to the size of the economy. A decline in the current account deficit

reduces the need to import capital and is a positive for the dollar.

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Overall, we believe these factors will lead the U.S. dollar to trend higher over

the next year. If we are right, there are implications for investments.

What advice would you give investors if the dollar does continue to rise?

U.S. bonds will likely outperform foreign bonds from developed countries and

emerging markets. Currency appreciation or decline can be a significant factor

in determining the total return when investing in the international bond

markets. If the dollar continues to appreciate, then the return on foreign bonds

is likely to lag behind the return on U.S. bonds. This is especially true in the

developed country bonds, where yields tend to be lower than in the U.S. Even

among the countries with higher bond yields, such as Australia, the yield

spread versus U.S. bonds is relatively low compared to a year ago and may not

compensate for the risk of a further decline in the currency.

If the dollar continues

to appreciate, the

return on foreign

bonds is likely to lag

behind the return on

U.S. bonds.

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Emerging market bond yields are higher than in developed countries, but EM

currencies tend to be more volatile and can have a bigger impact on the total

return of a bond investment. Moreover, we believe the exposure of many EM

countries to a global slowdown is higher than it is for the U.S. While every

country is different, on average EM countries rely more heavily on exports as a

percent of GDP growth than does the U.S. Since the currency component of

total returns in EM bonds can be significant, they are likely to continue to

underperform U.S. bonds in a rising U.S. dollar environment.

Most EM countries have floating rate currencies today as opposed to the case in the 1990s. How does that impact this idea?

EM countries are better positioned today than in the past to withstand a

changing interest rate environment, but that flexibility is largely due to the

adoption of free-floating currencies over the past decade. The ability to let the

local currency decline when interest rate differentials widen vis-a-vis the U.S.,

can make it easier to repay the debt than if it were denominated in U.S. dollars.

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Are dollar-denominated EM bonds immune to currency effects?

Even U.S. dollar-denominated EM bonds could underperform in this

environment. While the currency component is not as significant to total

returns as it is in developed country bonds, capital flows into EM countries

tend to decline when their currencies are falling. IMF studies indicate that

capital flows to EM countries tend to slow down within three to six quarters of

a U.S. rate increase and vice versa. From 2010 to 2013, capital flows to EM

countries increased by $1.1 trillion per year compared to an average pace of

$697 billion per year for the prior three years, according to the IMF. Since the

end of 2013, capital outflows from EM countries have increased sharply,

sending those currencies lower. With the Fed likely to raise rates next year, the

outflows are likely to continue.

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What are the risks involved with this investing idea?

While we believe reducing exposure to foreign bonds when the dollar is rising

makes sense, there are risks to consider.

• International bonds offer valuable diversification in an overall portfolio.

By reducing that exposure, an investor loses some of the benefits of

diversification.

• The path of the U.S. dollar is not certain. We could be wrong in our

expectations of a bull market for the dollar to continue. The Federal Reserve

might hold off longer on tightening monetary policy than current market

expectations suggest, which might result in a weaker dollar.

• Global growth might rebound more sharply than we anticipate, causing

currencies of countries that rely more heavily on exports and trade to rise

relative to the U.S. dollar.

• Expectations are for the Fed to begin tightening its monetary policy this

year, which could prompt a move higher in U.S. Treasury yields. Since bond

yields and prices move in opposite directions, this could lead to low, or even

negative, total returns for U.S. bondholders even if the dollar continues to

appreciate.

How will the bullish dollar affect commodity prices?

A strengthening U.S. dollar has contributed to the underperformance of

commodities as an asset class. Since most globally traded commodities are

traded in U.S. dollars, a stronger dollar tends to send the prices of

commodities lower, all else being equal.

Let’s look at an example:

Crude oil is globally traded and priced in U.S. dollars, which means if a

company in France imports oil from Saudi Arabia, it will need to pay for that oil

in U.S. dollars. That requires exchanging euros for dollars in order to conduct

the transaction. When Saudi Arabia receives payment in U.S. dollars, it needs

to either convert those dollars to its own currency, the riyal, or invest those

dollars in U.S. assets.

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If the dollar appreciates in value relative to the euro, then the cost of the oil will

increase by the same amount to the French company importing the oil. If the

dollar’s rise is broad-based against a large number of currencies, then the cost

of oil will rise for most or all importers. Consequently, in an efficient market,

the nominal price of oil will adjust lower to compensate for the change in the

dollar’s value. Or demand for oil might decline due to the rising cost, which in

turn would put downward pressure on oil prices.

Some commodities are more sensitive to the dollar’s changing value than

others, but all showed some correlation between the movements of the dollar

and movements in the prices of commodities. We looked at the relationship

between the dollar’s movement and the price index of four different commodity

groups over the past twenty years on a monthly basis. We found that precious

metals prices appeared to have the lowest correlation with the dollar’s

movement, while agricultural and energy prices had higher levels. The

R-squared readings in these four charts show how much of the movement in

the commodity price can be explained by the movement in the dollar. A higher

R-squared indicates a higher relationship and generally speaking, any reading

above .25 indicates that the relationship is statistically significant. When the

chart’s line is sloping downward it indicates that a lower dollar is related to

higher commodity prices and vice versa.

Commodity prices tend

to drop when the dollar

rises.

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What other factors are contributing to the downtrend in commodity prices?

Prices have declined due to rising supplies of many goods - from oil to corn,

coupled with slowing demand due to faltering global growth. We expect these

trends to continue over the next year.

Strong global growth, spurred by China over the past decade, led to increasing

demand for basic commodities such as iron ore and oil. Consequently,

commodity prices rose steeply. Now increased supply has caught up with

demand. High prices led to big increases in investment in energy, agricultural

goods, industrial metals and precious metals worldwide. With the prospect of

large stockpiles of commodities and a slowdown in demand, prices have fallen.

A stronger dollar will most likely contribute to the decline in prices until supply

and demand are in balance.

There have been several such cycles in the commodity markets over the years,

but the recent cycle has seen the sharpest increase in prices in decades.

Based on the World Bank energy commodity index, the last time a move of this

magnitude occurred was in the 1970s. The index subsequently declined for

most of the next 20 years, after peaking in 1980. This cycle may be quite

different, but there is a case to be made that a decline in commodity prices

could last several years after such a substantial increase. A stronger dollar

could contribute to a longer and deeper decline.

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Important DisclosuresPast performance is no guarantee of future results. Forecasts contained herein are for illustrative purposes, may be based upon proprietary research and are developed through analysis of historical public data.

The information here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities and investment strategies mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. Data here is obtained from what are considered reliable sources; however, its accuracy, completeness, or reliability cannot be guaranteed.

All expressions of opinion are subject to change without notice in reaction to shifting market, economic or geopolitical conditions.

Indices are unmanaged; do not incur management fees, costs, or expenses; and cannot be invested in directly.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.

Investments in currency involve additional special risks, such as credit risk and interest rate fluctuations,

Commodity-related products, including futures, carry a high level of risk and are not

suitable for all investors. Commodity-related products may be extremely volatile, illiquid and can be significantly affected by underlying commodity prices, world events, import controls, worldwide competition, government regulations, and economic conditions, regardless of the length of time shares are held. Investments in commodity-related products may subject the fund to significantly greater volatility than investments in traditional securities and involve substantial risks, including risk of loss of a significant portion of their principal value.

International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.

Index definitions

World Bank Energy Commodity Index is a price index with fixed weights based on 2002-2004 average developing countries export values, for coal, crude oil and natural gas.

Trade Weighted U.S. Dollar Index: Other Important Trading Partners is a an average of the exchange rates of a country’s currency with the currencies of its most important trading partners, weighted to reflect each trading partners’ importance to the country’s trade. A currency’s trade weighted index is also known as its effective exchange rate. The currencies in the U.S. dollar index are the euro, the yen, sterling, the Canadian dollar, the Swedish crown and the Swiss franc. It was launched in 1973 with a value of 100.00.

Barclays Emerging Markets USD Index includes USD-denominated debt from emerging markets in the following regions: Americas, Europe, Middle East, Africa, and Asia. As with other fixed income benchmarks provided by Barclays, the index is rules-based, allowing for an unbiased view of the marketplace and easy replicability. Barclays International: Sovereign Index is a sub-index.

US Dollar Index (USDX) is an index (or measure) of the value of the United States dollar relative to a basket of foreign currencies.

S&P GSCI® (formerly the Goldman Sachs Commodity Index) serves as a benchmark for investment in the commodity markets and as a measure of commodity performance over time. It is a tradable index that is readily available to market participants of the Chicago Mercantile Exchange.

S&P GSCI® Agriculture Index, a sub-index of the S&P GSCI®, provides investors with a reliable and publicly available benchmark for investment performance in the agricultural commodity markets.

S&P GSCI® Energy Index, a sub-index of the S&P GSCI®, provides investors with a reliable and publicly available benchmark for investment performance in the energy commodity market.

S&P GSCI® Precious Metals Index provides investors with a reliable and publicly available benchmark for investment performance in the precious metals market.