Dollar will still reign supreme in 2016Article added by Bernice Napach on January 14, 2016
Bernice Napach

Bernice Napach

Joined: August 14, 2015

Almost without exception, financial strategists expect the U.S. dollar will remain the world’s top currency in 2016, but the bull market that saw the dollar appreciate 10 percent against most major currencies in 2015 is expected to slow.

“The dollar had a pretty explosive move already, based on the Fed hiking this year,” says Robert Sinche, global strategist at Pierpont Securities. “There is not a lot of further upside in the dollar, now, maybe 5 percent.”

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How much higher the dollar actually moves will depend in large part on how many more times the Federal Reserve hikes rates in 2016, says Sinche, noting that two more hikes are already priced into the dollar's exchange rate. But Fed policymakers meeting in mid-December forecast a 1.375 percent federal funds rate for the end of 2016, implying four 0.25 percent rate increases next year – two more than what the market is expecting.

Underlying the strength in the dollar is the divergence of global monetary policies, which grew even wider when the Fed raised short-term interest rates on Dec. 17 for the first time in almost 10 years. While the U.S. is raising rates and has ended its asset purchase program, other central banks, including the European Central Bank and the Bank of Japan, are lowering rates or holding them steady and are continuing their asset purchase programs or expanding them.

“Full divergence is not priced into the market,” says Marc Chandler, global head of currency strategy at Brown Brothers Harriman. The fed funds futures market is currently pricing in 40 percent odds for another Fed hike in March, 20 percent odds for June, 11% odds for September and 10 percent odds for December.

In its 2016 market outlook, Goldman Sachs analysts write that “despite the strength we have seen so far, we believe the USD has more room to appreciate vs the EUR and JPY,” referring to the dollar, euro and Japanese yen. Its 12-month forecast has the euro trading below parity to the dollar at 0.95, which translates into 1 euro worth 95 U.S. cents, down from $1.08 currently.

Goldman’s forecast for dollar/yen is 130 – one dollar worth 130 yen - up from 121 currently. But Goldman notes these targets could be reached sooner, before year-end 2016. Its top recommended trade for 2016: “Go long USD against an equally weighted basket of EUR and JPY at 100, with a spot target of 110 and a stop loss of 95.”

Investors who aren’t trading currencies should still be conversant in dollar exchange rates because the currency can be a key factor in the performance of various investments, including the stocks of companies with sizable revenues coming from overseas, foreign stocks and bonds and commodity-based investments since commodities are priced in dollars. When the dollar rises, the price of the commodity falls if other factors haven't changed, and vice versa, but supply/demand fundamentals are also crucial for the price of commodities. In the case of this year's collapse in oil prices those fundamentals were more important than the rise of the dollar.
”The trajectory of the U.S. dollar is pivotal,” writes John Bilton, head of global Multi-Asset Strategy at J.P. Morgan Asset Management, in the firm’s 2016 Asset Allocation Views report.

That is clearly the case in the earnings performance of S&P 500 companies this year. FactSet estimates that earnings for S&P 500 companies in 2015 will grow 4.7 percent for those companies with more than half their sales based in the U.S. Earnings at companies with more than half their sales coming from abroad are expected to fall 7.4 percent. That’s a spread of more than 12 percentage points.

Sinche expects the drag from currency translations on earnings will begin to moderate in 2016 but the effect on competitiveness, which has lagged, will not. “The dollar will still be a bit of headwind for international companies as we go through the year,” says Sinche.

The dollar’s bull move has also been a key factor in the performance of foreign markets especially emerging market stocks and emerging market debt denominated in dollars. The rise of the dollar and decline of foreign currencies has also wiped out some or all of the gains for U.S. investors in those markets.

If they invested in a German DAX Index fund, for example, they would have lost about 4 percent, but if they had invested in a fund that hedged the currency exposure, they would have gained more than 5 percent, according to Chandler. Hedging can be expensive, however. How expensive depends upon the difference between interest rates of different countries. If the spread is wide and the foreign rates are negative or near zero while U.S. rates are positive, the cost of the hedge will be negligible, says Chandler.

He expects the euro will finish 2016 at 97 cents, and the dollar will end next year at 126 yen. Sinche forecasts the trade-weighted dollar index, now near 123, will end 2016 near 128.

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