The Dollar Flexes Its Beach Muscles

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You are wearing a black and white kind of speckled t-shirt, which it's the pattern that you would see on those composition notebooks that we used in school. Do I have that right?

Yeah, you're bang on. You're not supposed to wear these on TV because they screw up the camera and give everyone a headache.

The moiré effect, is that what they call it?

Yeah.

Is this part of— do you have like a whole Scholastic ensemble? Do you have like a—

It's laundry day.

Oh, I don't know if you have like a three-ring binder jacket to go with that. Maybe a protractor tie. All right. Good luck with laundry. This is the Barron Streetwise Podcast. It's not really about clothing. It's about sort of finance. I'm Jack Howe. With me, our audio producer, Jackson Cantrell. Hi, Jackson.

Hi, Jack.

We want to talk about the dollar. Let's be honest with ourselves. There's potential here for this topic to be a bit of a snoozer. People get jazzed up about stocks. They will dutifully listen about bonds and you start going into currencies. Uh, you know, you might, you might lose them. We've got to punch this up for folks. Let me set the stage a little bit, if I may. Let's say that you're an investor, you're an ordinary saver. You plunk a little of each paycheck into an S&P 500 fund. We all know that you've done quite well. You're like a stock picking genius this year, first of all, because the index happens to give the highest weightings to the biggest companies. And the biggest companies in America at the moment happen to be some of the ones with the best returns. Nvidia has more than doubled so far this year. Meta Platforms is up more than 40%. Alphabet and Amazon are each up more than 30%. So if you take that entire S&P 500 index, you're up a quick 15% for the year. And you don't have to tell your friends everything about how you did it. You can just tell them beating out 90% plus of fund managers. Exactly. Okay, so that we know. Here's what you might not know. You are also a currency genius because the S&P 500, like any US investment, it's an indirect bet on the dollar, and the dollar happens to be up nicely this year. One way to measure what's going on with the dollar is with something called the US Dollar Index. That measures how the dollar is faring versus the currencies of 6 trading partners: the euro, the Swiss franc, the Japanese yen, the Canadian dollar, the British pound, the Swedish krona. That index is up 4% this year. 4% is a big number when you're talking about forex or foreign exchange. And these investors have actually done a little bit better than that because you could argue that the dollar index is not really representative of the modern world. It was Created more than 50 years ago. It's a little bit musty and crusty. It's made only one change over the years in 1999 when they rolled out the euro to take over in the index for German marks and French and Belgian francs and Italian liras and Dutch guilders. So today the index is way, way into Europe. You could argue that it should have more Chinese yuan and Mexican pesos if it really wanted to represent the trading experience of the US. There are indexes for that. There are broader indexes that are weighted for the size of trading relationships. And when you look at one of those, it puts the dollar's increase this year at closer to 5%. Now, if you don't know that this is going on, it might be because you are a typical dollar saver, which means you're also a dollar payer. And when you're earning in dollars and saving in dollars and paying in dollars, you You don't really notice what dollars are doing relative to other currencies. I'll tell you who has noticed, our fine audio producer Jackson during his trip to Japan. Cheap, would you say, Jackson? Did you go to Japan? You went there because you wanted to, you had a passion about learning about Japan and it's not just because you saw that it was real cheap there right now, right?

Yeah, I had an opportunity to go on a bike trip with a friend, but once we got there, it was pretty amazing. Every lunch we had was around $8 with a drink and appetizer, and that dinners were $20, and hotel stays, once we split them, were like $30.

These are sit-down meals. These are not Happy Meal type. Yeah, yeah, yeah. The yen, the Japanese yen just hit a fresh 38-year low versus the dollar. So if you are a tourist, a US tourist, and you are booking a trip to Japan, prices that are maybe a third lower than they were 5 years ago, just from the currency swing. Basically, if you're an American who owns an S&P 500 fund and you're booking a trip to Japan, you are on the right side of just about all the big financial shifts that are going on in the world. Congratulations. You've nailed everything.

Woohoo.

Now, if you're not going to Japan, you're still, you're still benefiting from the, mostly benefiting from these currency swings. A strong dollar, it makes imported goods cheaper than they otherwise would be. There has still been plenty of inflation in the US, and it's still maybe a smidgen too high for comfort, and we're still stuck with all the price increases we have. But that inflation would have been worse if not for the effect of the strong dollar holding it down a bit. The flip side, of course, is that US exporters and their workers will struggle if the dollar grows too strong. Now, we did hear on this podcast last week from Jim Selinski. He's the global head of fixed income at Janus Henderson Investors. He spoke about bond investing and he touched on the dollar. That's last week's episode. This week, let's do this. We'll play right now part of a conversation I recently had with Kathy Jones. She's the chief fixed income strategist at the Schwab Center for Financial Research. And then later we'll hear part of a conversation I had with Kara Murphy. She's the Chief Investment Officer at Kestra Investment Management. I asked both about bonds, the dollar, the national debt, the upcoming presidential election, you name it. Somewhere in there, probably in between the two calls, I will say a few words about two topics you might not be familiar with. One is called the Dollar Smile Theory, and the other one is called The G10 Carry Trade. You won't want to miss it. I mean, you might want to miss it. I shouldn't—

Hey, you can't say that.

I shouldn't decide that for you. You should listen and then you can email me and tell me if in retrospect, if you would have wanted to miss it, but you'll definitely be glad you heard from Kathy and Kara. Let's get to Kathy now. Hey Kathy, Jack Howell from Behrens. How are you?

Fine. How are you doing?

All right. I've got some red itchy eyes only because I pet the dog and then I rubbed my eyes before washing my hands. Classic mistake. There's nothing you can catch over Zoom, so don't worry.

Actually, I'm allergic to almost everything that lives, so I understand.

That's a tough situation.

Yeah, yeah, the cats especially, more than dogs, but yeah.

Let's talk about what we should make of bond yields here. In the US, notably higher than in other developed markets. And what should investors do about that? Is that a good opportunity to lock in some yield?

Yeah, we think so, particularly versus international developed market bonds. When you look at that yield spread, we look at the aggregate bond index in the US, and then we look at the global index minus US, and that difference is 2%, 200 basis points. That's very wide by historical standards, and it's definitely makes the U.S. a much more attractive place to invest for income than it is in other developed markets. But we also think, you know, that we're going to see the Fed cut rates and inflation's coming down. And these aren't bad yields to lock in for the future.

What parts of the bond market do you think investors should favor right now?

Well, you know, the Treasury yield curve is inverted. So short-term rates above long-term rates. So it makes it hard to say, let's lock in 4.25% or 4.5% where you can sit in short-term and get 5.25%. So understand that hesitation for people. But we do like kind of a balanced, high-quality portfolio. So we like investment-grade corporate bonds. The yields are 5% to 5.25% at this stage of the game, and that yield curve is not inverted. That's actually flat to upward sloping, which means you get a little bit more yield as you go out in maturity, and that's the way bonds are supposed to be. Agency mortgage-backed securities, these are the ones that are backed by, you know, the government agencies. We think those can offer some opportunity to lock in, again, 5% plus.

For people who haven't dabbled there before, how would you compare the safety of those to Treasuries? Pretty close? And the yields, are you picking up a fraction of a point more generally in yield, or how would you characterize that for people?

The safety is similar to Treasuries. It's not 100% backed by full faith and credit of the government, but the agencies are backed by the government. So it's pretty close, right? In mortgage-backed securities, the risks are just different. So a lot of it has to do with how the mortgage market is faring. You know, are people refinancing or are they not? Are they initiating new mortgages, etc.? So you have more kind of duration risk there, interest rate risk, in terms of whether long-term rates move up or down. But you do get compensated for it. And we don't think that the, the future in the mortgage market is going to be higher rates and more, you know, more duration risk. We think that has pretty well played itself out.

How do you invest in bonds ahead of the US election? I think people watch that and they say, okay, based on, you know, if this candidate wins and if there's this, you know, party split or if there's a sweep of one party, here's how we should be positioned. So you don't necessarily know what's going to happen with the election. And then, I mean, how sure can you be that that strategy will pay off? Is it— do you do anything different with an election coming up, or do you just ignore it and keep doing the same thing?

We tend to ignore it. Um, my colleague Liz Ann Saunders has a great statistic, which I don't, I don't have the specific numbers, but basically if you started with $10,000 and invested back in 1924, you know, and invested only when Republicans were in office, that would now be $100,000. If you invested only with Democrats, it would be $500,000. If you just stayed invested, it would be $5 million. So, you know, the lesson is just keep investing. So I don't think you alter your long-term strategy based on who's in the White House in particular, because much of what we're hearing on the campaign trail is just talk. You have to get it through Congress. So the composition of Congress probably makes more impact on interest rates going forward than, than actual presidency does. I'll tell you what worries me about this election. Both sides seem to like the idea of tariffs, and tariffs have proven to be inflationary in the past. So there is a risk, I think, if we embrace tariffs, that we start to get more inflation pressure. And that's something that concerns me. So if you wanted to wait until after the election, see how Congress is made up, see how, you know, who's in the White House, you know, maybe you don't extend duration right away, or you buy Treasury inflation-protected securities for some of that inflation protection. Maybe you get cautious that way. But I always hate to try to play the politics because no matter what gets said on the campaign trail, what actually happens later can be totally different.

Whoever wins the election, what kind of economy and outlook do you think that they're going to inherit or take on? Is the outlook good now? And include in here the national debt for me, if you would. Is there hope? What's the path from here?

The economy's actually in pretty good shape. We have declining inflation. I know we have the accumulated impact of inflation that people still feel, but actually inflation, the rate of change in prices, is coming down pretty strongly. So we're— economy's still growing. I think it's cooling off, and there is some risk to the downside, but in general, we're still seeing consumer spending. It's cooled off. Consumers are more cautious, but it's still positive, and that drives the economy. Real wages are rising. People's wages are rising a little bit faster than inflation. That's good news. So in general, the economy's in decent shape, except for the deficit, as you mentioned.

Hold on, let me hit the music.

Yeah. Well, here's the bad news. We are, we have for decades now since the early 2000s been increasing spending and cutting taxes. So we're running about a 6.5% deficit, which in a non-wartime economy is highly unusual. If that trend were to continue, that's not sustainable over the long run. But having said that, it's not probably a 2025 problem or 2026 problem. It's, it's a long-term problem because, you know, we're the United States. We can run deficits. We can certainly attract a lot of capital. We're showing that at 5%, we can fund the deficit. We got a big strong economy, lots of assets. So we can pay the debt. It's our willingness to deal with the debt. That's the problem. That's the only, you know, I always often say if I could just sit every member of Congress down with an Excel spreadsheet and say, here's the assumptions from the Congressional Budget Office, you do the math. Right? You input where you're going to cut, where you're going to increase revenue. You tell me how it works out, not some fanciful ideas or theories about how it works, actual math. That's not going to happen because probably most of them have never seen an Excel spreadsheet.

The spreadsheet challenge is out there, Congress, if you're listening. We could probably get this sponsored and televised. People would love to see this.

No, I know. Seriously, if we could just sit down there and say, look, You know, this is a math problem. This isn't a theoretical economic problem. It's a math problem. It can be solved.

Thank you, Kathy. Coming up, I'm going to tell you a little bit about the dollar smile. What is it? Is it a Halloween costume? Is it a teeth whitening product?

Is it the wry smile of George Washington on the dollar bill?

That is a wry smile. But no, that's coming up right after the break.

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Welcome back to Time for the dollar smile. Jackson, you're on the edge of your beanbag chair.

It's actually an ottoman, and yes.

Okay, so this is a theory that was outlined more than 20 years ago by someone named Stephen Jin. He used to run currency research at Morgan Stanley. Today he's the co-founder of an asset manager called Horizon SLJ Capital. So the dollar is the only currency that seems to have this, nonlinear relationship with the economy, meaning it tends to shine during two completely different scenarios. And those are the two corners of the smile. The left corner of the smile, that's times of global recession or financial panic. Fearful investors stampede towards treasuries and other dollar assets for what they perceive as safety. The right corner of the smile, that's periods of peppy US growth. It often comes with rising interest rates or the belief that interest rates are going to rise. The middle or the lowest part of the smile, that's when the US economy is underperforming the rest of the world. And it's during those periods that the dollar tends to fall. So where are we now? It's not an exact fit, but we're closer to that happiest part of the smile, the right corner. Economic growth in the US has slowed. It was an annualized 3% and change toward the end of last year, and it fell to 1.4% annualized in the first quarter. Forecasts suggest it might speed up just a smidgen in the second quarter. You compare that with the eurozone, their growth turned positive in the first quarter after 5 straight quarters of stagnation. But eurozone growth is not expected to top 1% this year. Japan's economy is shrinking. China has an aging crisis and it's filled with unsold homes. Many developed markets are already cutting interest rates to spur growth. Japan is an exception to that, but it has lifted its rates to barely positive levels from negative ones. The US stands virtually alone here. The Fed funds interest rate is targeted at a range of 5.25% to 5.5%. That is plump compared with what's going on in other developed markets. Okay, so there's something called a carry trade. If you're a currency flipper, this has been an easy way to make money for years. You borrow chiefly in one of the safer slowpoke economies and you put money to work in a higher yielding economy that's risky but improving. What you hope for is low volatility, but lately you've had some emerging market currencies that have made drastic moves. There were surprise election outcomes in Mexico and India, and you had sudden currency drops and stock market drops for both. The hot forex trade of the moment is something called the G10 carry. G10 stands for Group of 10, which is, Jackson?

10, 10 countries that all have the tallest people.

No, but the Netherlands is on the list and I think they're tall.

The 10 countries with the most people named Carrie.

I like that, but I'm afraid not. The Group of 10 is a group of rich countries that have agreed to provide a backstop for the International Monetary Fund. The IMF has like a lot of groups. There's a Group of 7. Those are mostly rich. Also Group of 10, those two, and Group of 20.

This is sounding like a college football conference.

There's a group of 77, and that group includes— I'm looking over the list here— Haiti and Togo and Tunisia and Bhutan. I think the idea there is that you group together and you have more sort of sway or oomph, or you speak with a louder voice when you speak together. That's more than you need to know about the groups. Does it matter that the group of 10 has 11 members? It doesn't. Switzerland was a late joiner. It has limited role. No one bothered to change the name. The important thing here is that when you say G10, you're talking about rich countries, developed markets, you might say. And the G10 carry means this: you no longer need to borrow in some cheap, boring currency and put your money to work in emerging markets to earn a big yield differential with the possibility of currency gains. You can now borrow in a cheap, boring country and put it to work in the US dollar because yields here are pretty darn high. And the dollar has been gaining in part because forex traders are piling into the G10 carry.

So should we all get on the G10 carry trade or—

There are mixed views on what's next for the dollar. JPMorgan just published its foreign exchange mid-year outlook and it expects the dollar to stay elevated. Even once the Federal Reserve begins cutting interest rates, which it's widely expected to do later this year, that might bring down U.S. yields, but it won't necessarily bring down the yield differential. That's because everybody's cutting. 78% of central banks are expected to cut interest rates during the fourth quarter. That's the highest percentage since 1985. JP Morgan estimates that if the Fed delivers 5 rate cuts by the end of next year, 2024, 2025, the dollar instruments will still yield more than 50% of currencies globally. So if the yield differential holds, dollar strength might hold too. Not everyone agrees fully with that take. Let's listen to part of a recent conversation I had with Kara Murphy. She's the Chief Investment Officer at Kestra Investment Management.

The strength of the overall dollar, and this is the part that I think can sometimes get lost, is a massive competitive advantage for the U.S. economy. So as we think about our ability to have things like oil markets priced in dollars, to have other countries have their reserves in dollars. That's a huge advantage both economically and politically. But that goes to another issue, which I think has been sort of brewing under the headlines a little bit, which is that many, many non-US central banks have been diversifying out of the dollar. And they are seeing this, you know, sort of hegemonic role of the US dollar in global economics and saying, you know what, we're not super happy with that. So we're going to start investing elsewhere. So If we look at many central banks around the world, they have been selling dollars and buying other stuff. And it's not the usual suspects, right? It's not the euro or the yen. They've been buying things like the Chinese renminbi, the Australian dollar, the Canadian dollar. And this is a, a both economic and political long-term strategy to try and diversify outside of this like US hegemony. And they've also been buying gold. And, and actually I think the central bank buying around the world of gold has been the big driver of the rally in gold more recently. I think US policymakers should really take heed that very slowly their sort of, you know, dominance on global markets is being chipped away at.

What should that mean for policymakers, that they should use this advantage that we have while we have it? I mean, what, scold these people, what should they be doing right now?

Yeah, so, and be responsible policymakers, right? So that's one thing. You know, we count on the Fed to sort of, to take a very kind of careful path and manage the US economy and the value of the dollar well. I also think not using the dollar necessarily as an aggressive tool, right? So we see presidents talking about the strength of the dollar, the weakening of the dollar. Be very careful because there are many downstream implications if you start trying to nudge that currency in one direction versus another. And I also think the third piece of it is the aggressive use of economic sanctions. And so I'm not saying that we shouldn't use those economic sanctions, but but know that there are consequences to using them. If we try and, you know, block Russia from being able to access economic markets, it does mean that other countries are going to take heed and say, hey, I don't necessarily want to be at risk of that happening going forward. So we need to use it really sparingly.

Do you think that we're going to enter a period of, you know, gradual decline in the strength of the dollar? What do you think's coming?

It's been a really bad move anytime in the last 35 years to make a call against the dollar. So I think safer is to say that the rise that we've seen in the dollar over the last couple of years is not likely to continue.

And is there anything that an investor should be doing differently? Let's take the case of an American investor. I mean, they earn dollars and pay dollars and they hear about a strong dollar, but they're not quite sure about how it affects them. Is there anything in their asset allocation or portfolio or savings that they should be doing differently?

Yeah, it's a really good question because I get questions like that in a number of different ways. One is, well, how do I prepare my portfolio for the potential of a weakening dollar? How do I prepare for political dysfunction in the US? Um, how do I prepare for higher valuations? All of that leads to a really boring answer, which is diversification. And it's been really hard to sort of promote this idea of diversification when for the last 15 years, by far the best asset class has been the S&P 500. But we do think that these things have long trends and then they turn. And so at some point, if the dollar slows, if non-U.S. markets take the lead, you want to be able to have exposure there within your portfolio.

So 100% allocation to Nvidia stock is not the— that's not the best positioning necessarily going forward.

It's so tempting, though, right?

So, so you want to have what, overseas stock markets, even if they haven't done as well as the U.S.? And overseas bond markets too? What are we talking developed markets, emerging markets? What areas are most important for diversifying or just everything?

So we see opportunities in the non-US equity markets. So you get, you know, a good benefit from diversification. So for practitioners like us who build portfolios, you want to be able to have assets that you think can not only increase, but increase in a different path than your home assets, right? And so, so non-US equities get you there. On the fixed income side, it's a little bit different where, you know, the US US still has very broad and deep bond markets. And then if you look to many other developed bond markets, you're not getting a benefit from a higher yield. In fact, yields are substantially below where the US is right now. So there are some areas sometimes within EM debt or some other kind of nichey areas that you can add. But by and large, we don't— we generally don't have a strategic allocation to non-US bonds.

What should a bond investor expect here, or, or a saver who's, you know, trying put some of their money into bonds? Should they think that these yields that we're seeing now in the US, that they're getting is good here, or that they're going to see higher yields in the future? What do you expect?

So I think, you know, when we compare where yields are today versus the last 10, 15 years, these are by far the best yields that we've been— that any investor's been offered. Now, if you look at the performance over the last 2 years, it's been dismal. So it's hard to kind of forget that and think about the broader picture. And often yields is a really good indication of what your overall return is going to be, right? So value value of the bond stays flat and you earn that yield over time.

I'll just tell you quickly on that note, I had a friend ask me to look at his portfolio. He says, everything's doing great. He says, I got this one thing in here. It's just killing me, killing me. I go, what is it? He goes, right here. It's US government bond fund. It's like, he says, what should I do with this thing? Go ahead. That speaks to your point. Anyhow, go ahead.

It's a great example, right? Because we think about US Treasury markets as like the safest in the world. But they can go down, right? And the last few years is a really great example. And the further out you've been on the curve, the more dismal that performance has really been. But again, like, we've had that bad performance, we've had that step down in bond prices, and now the step up in yields. And looking forward, we think, you know, over the medium term, that's a pretty rich environment to be in.

Thank you, Kara, and thank you, Kathy. And thank all of you for listening. Jackson Cantrell is our producer. Jackson, I'm out the next 2 weeks. You know that, right?

You're out the next 2 weeks. Well, enjoy it. Enjoy your vacation.

Thank you. I know you're not supposed to tell people ahead of time that you're going to be away because they might not listen, but I don't want people to tune in for a new episode and get a rerun if that's the plan. You might have a different plan. I leave it in your hands. What's the plan? Are you going to— are you going to do a Jackson episode?

Yeah, I'll do a couple, couple interviews and, and maybe I can call you in from Tahiti or wherever you are to do some listener questions at some point.

Even better, Kentucky.

Nice.

We'll see what happens. You can follow the podcast on Apple Podcasts, Spotify, YouTube, or wherever you listen. Thanks. And Jackson is looking forward to seeing you next week.

Data is everywhere, but is it ready for consumption? Morningstar developed the language of global investment data so you have the right ingredients to help you shine. Morningstar, where data speaks.