The Dollar’s Move Is More Dangerous Than You Think

dollar etfMichael Lewitt: With earnings season here, what’s lost in the “oohing and aahing” over the incoming results is a reasoned look at what’s influencing the dollar’s move and, more importantly, the effect it will have on our wallets, if not today, certainly down the road.

Earnings and corporate reports are a long game, and that game is in the early innings. Investors need to understand the reasons behind the strength in the dollar, why it is likely to persist, and how we need to prepare…

Big Earnings Are Masking Bigger Problems

The first big multinational company to report earnings was Johnson & Johnson (NYSE: JNJ), and the pharma giant announced respectable earnings but noted a heavy hit from the dollar:

“On an operational basis, sales were up 3.1% and currency had a negative impact of 7.2%[emphasis mine].  In the U.S., sales were up 5.9%. In regions outside the U.S. our operational growth was 0.8%, while the effect of currency exchange rates negatively impacted our reported results by 13.2%.”

Make no mistake about it: 13.2% is an enormous currency hit. While the company also reduced guidance based on expectations of continuing currency pressures, the stock held up until a slight retrenchment late in the week.

The market apparently believes that currency, like oil, will have only a transitory impact on earnings.

An even more egregious example of the euphoria over strong earnings masking currency losses is Netflix Inc. (Nasdaq: NFLX). The company announced massive subscriber growth and stronger-than-expected bank earnings but included this acknowledgment of currency issues in its earnings report: “The strong dollar hurt financial results during the quarter, negatively affecting International segment revenue (lower by $48 million y/y using Q1 2014 forex rates) which carried into a $15m negative forex impact on international contribution losses.”

Yet, as has been customary during the post-crisis bull market, any bad news related to the oil crash or dollar strength is being explained away as transitory, and indeed, NFLX stock soared over 18% on the news.

That may prove to be a serious mistake.

Indeed, the market as a whole is making a big mistake by ignoring the effect of the strong dollar; its impact is just beginning to be felt.

Here’s what’s going on that companies are burying in the small print of press releases.

The dollar’s strength is being driven by the divergence in monetary policy between the Federal Reserve and central banks in Europe, Japan, and China. While the Federal Reserve is moving to tighten policy by ending its program of buying bonds (known as “QE” or “quantitative easing”), other central banks have loosened their policies by launching trillion-dollar programs of their own to buy their regions’ bonds (as well as stocks, in the case of Japan).

Monetary policy is driving the value of the dollar and the rest of the world’s currency in starkly different directions.

In addition, the Federal Reserve is openly discussing plans to start raising interest rates later this year; there is little prospect that European or Asian central banks will do anything similar for years.  As a result, interest rates in the United States are expected to move up while those in Europe and Asia are moving down. In fact, rates in much of Europe have been pushed below zero, which is creating huge problems for investors who need to earn a decent return on their capital.

Ten-year U.S. Treasuries were recently yielding 1.89%, which is pathetic, but 10-year German bunds actually hit a microscopic 0.08%, and 10-year Japanese bonds are trading at 0.32%. If you were an investor who had to buy one of these meager offerings, which one would you pick? The differential in interest rates is driving currencies in opposite directions and is likely to keep doing so for a long time.

Since the beginning of the year, the euro has dropped by about 10% against the dollar (from $1.20 to $1.07), a huge move in such a short period of time. The yen has traded flat at about ¥119 but is poised to drop significantly, having dropped sharply from ¥76 in January 2012 after Shinzo Abe was reelected as Prime Minister and implemented a radical policy to devalue the currency to stimulate Japan’s moribund economy.

Both the European and Japanese economies are drowning in debt and encumbered by archaic regulatory, labor, and tax regimes that doom them to slow growth, leaving policymakers with currency devaluation as their only hope – a dim one – to stimulate growth.

Weaker Currency Is Catnip for Foreign Markets

The U.S. Dollar Index (INDEXDXY: DXY) tracks the U.S. dollar against a basket of major currencies. Last December, it broke a 30-year trend line when it rose above 95. Recently it hit 100 before dropping back below that and is currently trading at around 98.

The most astute technical analysts on Wall Street suggest that it could easily hit 110 or 120, which makes sense if you look at where the euro and yen are likely to move. The euro is likely to weaken much further against the dollar, not only moving to parity ($1.00) but eventually trading in the $0.80 range. This is based on the fact that the European Central Bank and its president, Mario Draghi, have made it clear that their policy is to weaken the currency much further.

With interest rates at or below zero, the only tool they have left to stimulate economic growth is to cheapen the euro to make European products more attractive abroad and grow the region’s exports. They are content to pick up the pieces from a policy that will destroy their currency and their banking system later.

As for Japan, the yen recently crossed a long-term trend line at 121 before dropping back below it. But the clear mandate from Prime Minister Abe is tocheapen the currency in order to stimulate exports and inflation. Among other things, this is setting up a currency and trade war in Asia among Japan, China, and South Korea that will export lower prices and deflation throughout the world. In the race to the bottom, Asia will be a major player.

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