The most recent FOMC 2-day policy meeting brought a change in their policy language that it could start to reduce, or ‘taper’, its $120 billion in monthly asset purchases as soon as its next scheduled meeting, November 2-3. New projections released at the end of the most recent Federal Reserve meeting showed half of the 18 officials expected to raise interest rates by the end of 2022.
Guide to Understanding Global Implications for U.S. Dollar Strength
The prospect of a Fed taper and rising rates marks a turning point in the easy money, accommodative monetary policy that has dominated the backdrop of the falling dollar throughout the Covid crisis (see chart below). The early initiation of a Fed taper sends a clear message to global currency markets that the U.S. is serious about cooling the economy down to tame the flames of inflation. This comes at a time when the rest of the world is still recovering from Covid and stimulating their economies to reflate prices, commodities, and spur economic growth. In short, any efforts to reduce forecast levels of U.S. inflation relative to other advanced and emerging market economies, will serve to strengthen to U.S. Dollar relative to the basket of global currencies. The recent U.S. Dollar strength can be seen in the chart below.
Evidence that U.S. Dollar Strength can Become a Headache for US Multinational Companies
Look no further than the YTD price performance of Deere & Co (DE) vs. Caterpillar (CAT) relative to the S&P 500. Note in the chart below, DE is +28%, S&P 500 is 17% and CAT is 7.5%.
However, just when you think the prospects for a $3.5 trillion infrastructure package would serve as a tailwind for the likes of DE and CAT, the threat of inflation and subsequent U.S. Dollar strength in response to the expected change in Fed policy has eroded the 3-month performance of both DE and CAT relative to the S&P 500 such that both DE and CAT are now underperforming the S&P 500.
Why will CAT Suffer More than DE in the Face of a Rising U.S. Dollar?
To understand why CAT suffers more from a stronger U.S. Dollar, you must understand that CAT has more international and more specifically, emerging market revenue exposure than its DE counterpart.
How the U.S. Dollar Strength Becomes a Global Headache?
Here are the 4 main global implications for U.S. Dollar strength and be thinking about how each will impact CAT more than DE longer term based on relative overseas exposure:
Demand for U.S. Goods - U.S. goods become more expensive to the rest of the world when weaker native currencies are exchanged for stronger U.S. Dollars required to consume U.S. exports. Demand for U.S. exports will weaken as the dollar gains strength.
U.S. Multinational Revenues Generated Overseas – Revenues generated overseas become worthless when converted from a weaker native currency to a stronger U.S. Dollar thereby reducing revenue growth in USD$ for U.S. multinational corporations.
Emerging Market Debt Service – Realize that the vast amount of emerging market debt is denominated in USD$ and therefore debt repayment will become more expensive for emerging market companies as the U.S. Dollar strengthens against the basket of global currencies. Recall the price performance of CAT and its exposure to emerging markets! Debt financing for the outlay of CAT capital expenditures can get very expensive in the face of a rising U.S. Dollar.
Global Capital Flows – As interest rates rise in anticipation of the Fed taper and subsequent interest rate increases set to begin as early as 2022, global capital flows will be drawn further from developed and emerging economies as U.S. Treasury yields rise and attract more foreign investment.
In short, you can see in the Price and Earnings charts below, that neither DE nor CAT are immune from the pressures of a rising U.S. Dollar but clearly, CAT remains more exposed given their greater dependence on overseas sources of revenues.
Price & Earnings - Caterpillar, Inc
Price & Earnings - Deere & Co
The U.S. is now entering mid-cycle ‘normalization’ and entering the tightening phase of the economic cycle while the remainder of the world is still deploying stimulus. As a result, the U.S. Dollar is expected to rise further from current levels.
Be sure to keep this post handy for future reference so that you can be reminded of the global implications for U.S. Dollar strength!
Information contained herein is based on data obtained from sources believed to be reliable, however, such information has not been verified by Carlton Financial Group, LLC d/b/a Carlton Wealth or Synergy Financial Management, LLC. The information provided has been prepared and distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy or an offer of advisory services.