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Take These Best Plays as Rate Cuts and a Strong Dollar Plague Markets

0 | By Shah Gilani

In spite of the Federal Reserve lowering rates, the U.S. dollar has been strong and getting stronger.

There are several reasons why the dollar’s appreciating and lots of implications for stocks and bonds.

It made sense when the U.S. dollar started rising as the Federal Reserve began raising rates in 2015.

When interest rates in the U.S. were higher than in other countries and the Fed announced it was going to start “normalizing” rates (raising them from artificially low levels) as the economy showed better strength, as deflationary fears gave way to talk about inflation prospects, as equity markets climbed higher, it made sense the dollar would strengthen.

That’s because when rate differentials widen, when the U.S. raises rates while other countries’ rates remain the same, money flows into the U.S. so it can be invested in higher yielding instruments.

In order to buy dollar-denominated U.S. Treasuries or U.S. corporate bonds, foreign investors must exchange their currencies into dollars. Those transactions, done in huge volumes, raises the dollar’s value relative to other countries’ currencies.

But the dollar didn’t move up dramatically against other currencies, because most of them were doing better economically too, and their central banks were expected to end their quantitative easing programs and eventually start to raise rates too.

But that didn’t happen…

Fast Forward to 2018

Instead of other countries raising rates, talk of slowing manufacturing and diminished economic growth elsewhere fed fears of pending recession, and instead of ever raising rates, other countries’ central banks announced prospective cuts if conditions continued to deteriorate.

With the Fed raising rates more 2018 and other countries talking about lowering their rates, and lowering them in 2018 and even more in 2019, the dollar began moving up more.

The dollar’s now up 11% from its 2018 lows and based on the ICE Dollar Index, an index of the dollar versus a basket of six major currencies, it is near its highest point in the past two years.

Even if the Fed lowers rates again in September, as they’re expected to do, the dollar should continue to rise because other countries are being more aggressive in lowering their rates already.

That keeps the rate differential wide enough to attract more money into the U.S.

Too bad a strengthening dollar isn’t always good. In fact, it can be quite detrimental.

It’s detrimental to the stocks of multinational companies who get substantial revenue from overseas.

That’s because when those companies tally their overseas earnings in local currencies and then must translate those earnings into dollars, the revenue they earn in other currencies won’t buy as many dollars when mathematically converted. That makes earnings fall and that knocks stocks.

Already, looking at second quarter earnings alone, companies with substantial overseas revenues saw their earnings fall, on average 12%, due to currency headwinds.

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Meanwhile, according to FactSet, companies with predominantly domestic revenues saw their earnings rise on average 4%.

If rate differentials widen further, companies will see more currency headwinds, analysts will start knocking down earnings forecasts and investors will take note by taking profits and short sellers will start adding pressure onto those companies’ stocks.

Bonds aren’t immune from a strengthening dollar either.

Domestically, bonds have been rising in price as yields have been falling in anticipation of the Fed lowering rates to slow appreciation of the dollar.

Lower rates here, driven down by market forces not the Fed, feed the narrative that investors are running to the safety of bonds in anticipation of a recession, even though there isn’t one in sight.

That rush into bonds, which is good for traders who played the bond rally beautifully, creates more distortions in U.S. companies that don’t deserve to float more debt but are able to sell high yield bonds as investors seek whatever high rates they can get in a declining rate environment.

It’s a lot worse for emerging markets bonds.

Emerging market economy companies often borrow in the U.S. dollar-denominated debt market. That’s because U.S. investors are willing to buy higher yielding emerging market company debt.

But, as the dollar rises, those companies that borrowed in dollars see the cost of their debt service rise quickly on account of their local currencies not buying as many dollars as they used to.

That makes the cost of interest payments rise as the value of their bonds declines. That’s a double whammy.

According to the Institute for International Finance, as of the end of the first quarter of 2019, there’s $6.4 trillion dollars of dollar-denominated emerging markets debt, up from $2.7 trillion a decade ago.

On top of all the emerging market debt woes that wreak havoc when the dollar rises substantially, a lot of emerging market economies are big commodity producers. Since most commodities on the world market are denominated in dollars, as the dollar rises, commodity prices fall because it takes fewer dollars to buy the same amount of a commodity.

And that’s going to add to emerging markets debt problems.

But the problems a strengthening dollar creates aren’t all bad, if you know how to play them.

In my newsletters we’re going to be buying instruments that rise in price when domestic rates fall, as we know they will because the Fed and the President don’t want the dollar to get too strong.

We are going to buy puts on emerging markets debt and profit when that debt market falters hard.

We’re going to short some emerging markets countries.

We’re going to short some commodities too.

That’s what we’re going to do to profit from the strong dollar.

You can do the same and enjoy watching the dollar rise, in fact, even cheer it higher.

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Sincerely,

Shah

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