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The Dollar Is Set To Rally -- Here's Your Playbook


At the end of World War II, thousands of U.S. soldiers stayed behind in Europe, either as active-duty soldiers or as tourists exploring the continent's cities and countryside.

A key source of appeal: The U.S. dollar was far more powerful than rival European currencies, making all kinds of European goods and services stunningly cheap.

Those days are long gone. And if you've been abroad in recent years, you haven't been hearing much about the almighty dollar.

In fact, measured against a basket of other top currencies, the U.S. dollar index has slid from 96 in 2004 to 88 in 2009, to a recent 80, according to FXStreet.com.

That steady slide has had a broad set of effects on the U.S. economy. Tourists have surely felt the pain, but many U.S. companies have been able to find a more receptive market for their exports. Global oil prices, which are also denominated in dollars, have also been boosted by a weaker greenback.

Get ready for the math to start going in reverse: In the years ahead, the stage is set for a dollar rally, which may impact your portfolio in unexpected ways.

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To understand the looming currency reversal, it helps to know how we got here.

First, the drop from 2004 to 2009 was due in part to the new euro, which got off to a slow start, but then began strengthening fairly quickly as the positive effects of the monetary union began to spread. Then, in 2008 and 2009, the Federal Reserve slashed interest rates to stave off an even deeper recession. Global currency traders quickly sold their dollars and reinvested their funds in other currencies that delivered higher interest rates. Other countries also cut their rates, but not to the extreme levels that the Fed had. And with U.S. rates remaining low ever since, there's been little reason for global currency traders to pivot back to the dollar.

Yet we now have a clear read on the future direction of U.S. interest rates: They're going up. 

First, the Fed is winding down in its bond-buying program. Then, at some point, perhaps as soon as early 2015 (or even later this year, as my colleague Joseph Hogue suggests), the Fed is expected to start boosting interest rates back to normal levels. It will be a slow process, but by the time it is complete, the U.S. economy may be performing in a much more robust fashion, especially in relation to still-beleaguered Europe. (Note that the euro accounts for 58% of the dollar index, with the Japanese yen and the British pound accounting for another 12% to 13% each.)

The dollar appeared to have put in a bottom just before the monthly employment report in early May. The stellar jobs report led many to conclude that the U.S. economy is moving onto a firmer growth path, and though the dollar's recent rebound has been modest thus far, recall from earlier that it stood above 90 a decade ago.

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 Source: CNBC.com

If the dollar strengthens around 10% over the next few years, what kind of effects should you expect?

One of the most important impacts will be seen in oil markets. A rise in the dollar is expected to lead to lower global oil prices, and prices for other commodities as well, for that matter. That's because foreign buyers, who will see their currencies weaken relative to the dollar, will need to spend more money to buy these dollar-denominated products. That has a direct impact on demand for these commodities. That should also blunt any inflationary pressures that emerge in the U.S. economy as it strengthens.

U.S. exporters are less pleased about the prospect of a rising dollar. Their goods and services become less competitive on global markets, and their earnings are reduced as foreign-earned profits are repatriated back into (stronger) dollars.

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Another impact of a stronger dollar: The value of foreign stocks and funds will diminish at the exact rate at which the dollar moves against a particular currency. A 10% rise against the euro would trigger a 10% drop in the value of a European investment in dollar terms (all other things being equal). 

The good news: The dollar's potential rebound is mostly expected to come against major currencies like the euro. Many emerging markets, which often possess robust growth prospects, are expected see their currencies hold their own -- with a big caveat: This only applies to countries that are net exporters, many of which are in Asia and Latin America.

Risks to Consider: The key risk to a firming dollar scenario is an expanding U.S. trade deficit. The U.S. is sharply reducing its dependence on imported oil, which is helping reduce America's negative trade balances. But if the U.S. economy grows at a much more rapid rate than those of key trading partners, then America will suck in a lot more of their imports, which could lead the trade deficit to swell.

Action to Take --> There are a lot of moving parts to the changing dollar scenario. The key takeaway is that the factors that led to the dollar's decline appear set to reverse. It's important to look at your whole portfolio to assess how a potential rise in the dollar would boost or hurt any of your holdings. It's also important to track the dollar's impact on the U.S. economy. A reversal in the decade-long downtrend would have positive and negative effects, depending on such factors as trade balances, interest rate differences, oil prices, and so on.

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