To Hedge Or Not To Hedge: Dollar Vs Euro

We’re going back to a topic that I think is becoming increasingly relevant in the current environment, yet getting shadowed somewhat by all of the vaccine-grabbing headlines.

“Question for you on the U.S. dollar… have you written on what the dollar might do versus other currencies, specifically the Euro?”

Needless to say, being on the wrong side of a significant swing in foreign exchange rates can cost a business thousands, if not millions, of dollars depending on the level of business. For investors with international equities or bonds in their portfolios, it can be just as important to consider since currency swings also impact the returns you’ll see on those positions.

The quick and dirty answer to the question above is yes. In the weekly Global View piece that typically gets published every Wednesday, I cover the global currency market and the issues that are impacting current exchange rates as well as where they may be headed in the future.

But let’s dive into this topic a little further. To set the table, here’s the five-year chart of the dollar index, which measures the dollar against a basket of global currencies.

US Dollar Index Cash Chart

There are a few different narratives at play here, which I think are all worth discussing to give a sense as to why the dollar is moving the way it is and what is influencing it.

• Rise during the 2nd half of 2016 - The dollar’s strength here coincides with Donald Trump being elected president. After some initial uncertainty, investors quickly grew bullish on Trump’s pro-business agenda. His plans at the time included corporate tax cuts, a potentially $1 trillion infrastructure package and a number of regulatory rollbacks. These, investors believed, would trigger the next wave of economic growth for the United States and forex traders similarly overweighted dollar-denominated assets.
• Decline throughout 2017 - The initial wave of pro-business optimism started to wear off for a few reasons. For one, investors grew less convinced that certain economy-boosting agenda items, including the infrastructure bill, would come to pass. President Trump’s unconventional style and antagonistic rhetoric as it pertained to foreign trade relations also dampened the mood. This was around the time that the U.S.-China trade war started picking up steam and the financial markets were growing less convinced the dollar was the place to be as tariffs would likely soften economic growth.
• Rise during 2018-2019 - The Fed was trying to slowly raise interest rates in an effort to return to a more normalized environment, but concerns were growing about a global economic recession. The worries were particularly high over in Europe, where interest rates were drifting into negative territory and there was a very real risk that the European banking sector could collapse (this risk still exists although mountains of central bank liquidity have somewhat lessened it). This made the dollar the choice currency again thanks to better than average GDP growth and steadily rising stock prices.
• Decline in 2020 - The COVID pandemic. Yes, the virus has impacted economies all around the world, so this isn’t just a domestic issue, but there’s a sense that the U.S. has been slow to respond and hasn’t taken some of the precautions that other nations have in stemming the outbreak. That, in turn, puts the U.S. at greater risk of economic impact. China has been the first nation to largely emerge from the pandemic and return mostly to normal and that has made Chinese equities and the yuan comparatively more attractive (although the yuan isn’t part of the basket that the dollar index gets measured against). The prospect of another round of Fed stimulus would also potentially dilute the value of existing dollars in the system.

In the end, the value of the dollar is driven heavily by the state of the U.S. economy relative to the world, but it’s also impacted by good old fashioned supply and demand. As dollars flood the economy, they become comparatively less valuable.

The original question was related to the dollar versus the euro, so let’s throw that chart up too.

USD/EUR Chart

It’s pretty much identical to the dollar index chart, which shouldn’t be surprising given the euro accounts for more than half of the dollar index.

With the economic outlook driving the dollar’s value versus the euro, let’s consider the major factors that could swing the exchange rate in either direction.