The dollar has experienced its sharpest rise in five decades. That, coupled with robust European and ongoing Japanese quantitative easing, has made investors increasingly wary. Understanding how the dollar achieved these remarkable gains is important in understanding the potential consequences.
A Perfect Storm
In response to the 2008 financial crisis, the Federal Reserve flooded banks and capital markets with liquidity. Contrary to conventional wisdom, the dollar strengthened, largely because global investors viewed the United States as the “best of the worst” in terms of risk. Global investors began exchanging their foreign currency for dollars to buy U.S. Treasuries, thus strengthening the dollar.
At the same time, foreign governments, anxious to rescue their economies by making exports more affordable, began to systematically reduce the value of their own currency by exchanging them for dollars. The collective demand for the dollar by investors and governments has steadily increased the strength of the dollar on the global stage.
Impact on the U.S. Economy
In a global economy where the U.S. dollar is the elephant in the room, the U.S. economy is gaining ground while most nations are struggling to achieve GDP growth. As you would expect, the strong dollar and growing economy will attract capital. Additionally, the Federal Reserve is about the only central bank hinting at raising rates. When that happens, the dollar will strengthen further.
As a consequence, U.S. exports are becoming more expensive. This is of particular concern to large multinational corporations earning as much as 40% of their revenues overseas. When foreign revenues are converted to dollars, corporate bottom-lines take a hit. For example, Pfizer Inc. anticipates a nearly $3 billion revenue hit as a direct result of currency impacts in 2015.
How Hedge Funds Are Responding
Hedge fund managers largely agree that the dollar will continue its rise. The Euro continues to experience downward pressure as the ECB lowers interest rates and the specter of the Greek exit still looms large.
Hedge fund managers perceive the rising dollar as a disincentive to any rate hike by the Federal Reserve; as such action would further strengthen the dollar and depress U.S. GDP growth. As a result, hedge funds pursuing a long/short equity strategy are relatively comfortable with their chosen tactic.
Forex hedge funds, particularly those focused on the USD/ Euro pair, are well-positioned to benefit from the strengthening dollar as are funds employing an emerging market strategy.
Even high risk global macro funds are exploiting opportunities in the strong dollar trend, anticipating a rise in European stock prices as a result of the ECB’s quantitative easing policy.
In short, hedge fund managers are seizing the opportunities offered by the strengthening dollar and the stage may be set for significant gains in the industry as 2015 unfolds. However, the continued uncertainty surrounding the question of when the Federal Reserve will implement a rate increase remains the principal driver of market volatility and will ultimately determine the future strength of the dollar relative to Euro and other major currencies.
