Caught in a Riptide
It’s been a while since international topics made regular headline appearances, but that might be changing. For the last year and a half, it seemed as though the only thing investors wanted (or needed) to talk about was the Federal Reserve, US economic data, US technology stocks, and Treasury bonds.
The tide has turned. That’s not to say those aren’t still big stories, but new topics have entered the chat and directed our attention across oceans.
For starters, economic data across the globe has diverged, with the US standing out as the only major country–at least in the chart below–with meaningfully positive economic surprises. The Eurozone and China have taken a decidedly negative turn over summer, while Japan and Emerging Markets remain… meh.
The takeaway for investors from indexes like this one above is more about what happened vs. expectations, rather than the absolute data that rolled in. It then becomes a relative game between countries – which one is more surprising than the other?
Using these indexes alone, it’s easy to see why the US stock market had a strong June and July (S&P 500 +9.8% over the two-month period): The expectations at the beginning of 2023 were leaning strongly in the “hard landing” camp, but over the course of the year as inflation fell, unemployment remained low and consumer data didn’t falter as expected, the surprise factor grew more positive.
Markets trade on expectations more often than they do on events. The difficult part is that these indexes are using data from prior periods to indicate whether we beat or missed expectations. So the expectations component is, in effect, backward looking.
But we invest for the future. Additionally, these indexes were originally created to explain more about currency movements across countries than stock and bond market movements. Yet the recent moves we’ve seen in stocks (up) and bonds (down) are attributed by many to stronger than expected economic data… of the past. See the rub?
Ride the Wave
Let’s talk more about what drives currencies, because the headlines have shifted not only to what’s going on across oceans, but particularly what’s going on in foreign exchange markets.
One of the main drivers of a country’s currency strength (or weakness) is the interest rate differential. This refers to the difference in interest rates between two countries, where the country with the comparatively higher interest rate would be expected to attract capital (since it pays higher interest), thus experiencing currency appreciation. The opposite is true for the country with the lower interest rate.
Given the skewing effect of inflation over the past year, the chart above shows real 10-year yields to make things more comparable. The main point of this is to illustrate the speed and magnitude of the rise in US yields versus other major nations. UK yields have been leading the way, but over the trailing one-month period, US yields have outpaced the others.
Left in the Wake
Needless to say, the US dollar has outpaced all other major currencies, in spite of countries such as China and Japan attempting to support theirs (the chart below shows the recent drop in other currencies and gold vs. the US
If we were in a normal economic environment, a strengthening currency along with a strong interest rate differential and improving economic data would all be positive signs for the US. And make no mistake, solid economic data is a good sign.
The trouble with this concept right now is that monetary policy has been taken to a restrictive level in order to constrict capital and cool economic data. So far, it hasn’t had the full intended effect, and inflation remains a concern.
There are a few other things that give me pause: Despite the stronger dollar and appetite for US interest rates, Treasury yields have continued to rise, putting pressure on the availability of borrowing across sectors. Additionally, a stronger US dollar makes our goods less attractive for foreign buyers, possibly putting pressure on multinational corporations who rely on international revenue.
Lastly, most commodities are denominated in dollars, and as the dollar strengthens, commodities become more expensive for foreign currency holders. That’s happening at a time when we are hoping inflation will continue to fall in an orderly fashion back down to its target level. Hmm…
At first blush, the recent dollar strength and broadening interest rate differential for the US may appear positive, but when added to the intended effect of monetary policy tightening, the typical effects of higher borrowing costs, and the possible headwind to US multinational corporations, the move looks more risky.
With our ever-interconnected global economy, nothing happens in isolation. The flow of headlines from other nations about debt concerns, currency weakness, and yield curve control has picked up considerably. I’d argue little to none of it sends positive signals about the near-to-medium term and it warrants a watchful eye, at the very least.
Communication of SoFi Wealth LLC an SEC Registered Investment Adviser. Information about SoFi Wealth’s advisory operations, services, and fees is set forth in SoFi Wealth’s current Form ADV Part 2 (Brochure), a copy of which is available upon request and at adviserinfo.Liz Young is a Registered Representative of SoFi Securities and Investment Advisor Representative of SoFi Wealth. Her ADV 2B is available at sofi.
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