How the Strong-Dollar Call Could Turn Out Dead Wrong

Amid all the turmoil in the stock and bond markets lately, many investors have forgotten about the big swings in the U.S. dollar recently. But some analysts believe that the rise in bond yields within the U.S. has dramatic implications for currency exchange rates in the future, and if their conclusions are right, they could have a big impact on your overall investment portfolio.

Morgan Stanley's currency experts upgraded their views on the prospects for further gains for the U.S. dollar in the near future. The strategists believe that with the possible exception of the euro, the U.S. dollar is likely to show strength against most major currencies. But is further dollar strength a sure thing? Let's take a look at some of the economic theories involved in making currency predictions and assess how predictions of dollar strength could turn out to be sorely mistaken.

Do rising yields boost currencies?
At its root, the connection between currency values and interest rates makes intuitive sense. When yields in a particular currency are low, income investors aren't particularly interested in moving assets into that currency, and as a result, exchange rates remain weak. By contrast, when yields rise, income-seeking investors get a lot more excited about income-producing assets denominated in that currency, and shifting flows of foreign exchange often bolster interest and send exchange rates rising.

We've seen the flip side of that trend play out in recent years, as rock-bottom interest rates in the U.S. have encouraged investment in higher-yielding income investments in places like Australia, Brazil, and South Africa. Interest from foreign investors got to be so extensive in Brazil that the federal government imposed a tax on foreign investors in bonds in order to curb demand and slow the pace of the Brazilian real's appreciation. Exchange-rate issues also likely played a role in the health of the commodities markets, as mining giants BHP Billiton (NYSE: BHP  ) and Rio Tinto (NYSE: RIO  ) in Australia benefited from increased demand largely for base metals. Similarly, South African gold miners AngloGold Ashanti (NYSE: AU  ) and Gold Fields (NYSE: GFI  ) outperformed rivals from elsewhere in the world, benefiting from strength in the South African rand currency.

Yet the other side of the theoretical currency debate is that higher yields in one country than another imply that the intrinsic value of the higher-yielding currency is declining faster. If that weren't the case, then the carry trade -- borrowing in a lower-yielding currency and then investing in income investments denominated in a higher-yielding currency -- would provide double benefits every time. Not only would investors get more income from the higher-yielding currency, but exchange-rate appreciation would allow those investors to exchange back to their original low-yield currency at a more favorable rate, providing additional profits.

When theory fails
At some point, taking a pragmatic approach becomes necessary to avoid getting trapped in theory. Historically, the carry trade has tended to work quite well over long periods of time, but eventually, some event reverses it and often leads to abrupt reversals in currency trends. That's what we've seen in Australia and Brazil recently, with the Australian dollar falling from US$1.05 to around US$0.90 and with the Brazilian real going from above US$0.50 to below US$0.45 in just the past couple of months, undoing years' worth of extra interest payments for carry-trade investors.

Looking forward, the relative strength of economies around the world will play a big role in currency direction. Those calling for dollar appreciation believe that the U.S. economy's strength will continue, with factors like ramped-up energy production helping to reduce imports and bolstering the fundamental strength of the nation's trade balance. Meanwhile, Japan and Europe are going through more severe austerity measures, while resource-driven economies like Canada, Australia, and several emerging markets stand to suffer at least short-term from the plunge in commodity prices.

But the strong-dollar call could prove dead wrong in two ways. If measures from foreign central banks succeed in reawakening global economic growth, then the unexpected strength abroad could bolster U.S. investors' interest in putting their money overseas again, boosting other currencies. Meanwhile, if the U.S. economy falters, whether from an unforeseen geopolitical event or from simply underperforming the relatively high expectations investors have of it, then interest rates could start to drop back again and lead foreign investors away from the dollar.

What to watch for
With currencies, relative movements are just as important as absolute ones. So as you look at economic data from around the world, don't just focus on whether news is good or bad but also on how it compares to other countries. That will give you the best clues toward the dollar's moves and help you see its impact on the multinational companies whose fortunes rise and fall with currency movements.

No matter what the U.S. dollar does, the best investing approach is to choose great companies and stick with them for the long term. The Motley Fool's free report "3 Stocks That Will Help You Retire Rich" names stocks that could help you build long-term wealth and retire well, along with some winning wealth-building strategies that every investor should be aware of. Click here now to keep reading.


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