The Tie That Binds

11/2/2015


No man is an island,
Entire of itself,
Every man is a piece of the continent,
A part of the main.

So begins John Donne's well-known poem about, well, interconnectedness.

What affects one affects all.

While I'm pretty sure Donne was not writing about the Federal Reserve when he penned this classic, Fed Chief Janet Yellen knows all too well that, in fact, no woman is an island when it comes to setting interest-rate policy.

Decisions made by the Fed have implications that spread far beyond Washington. And the tie that binds is currencies.

Many reasons, excuses, and rationales have been given for the Fed's reluctance to raise rates, but perhaps the most valid is the interconnectedness between interest rates and currencies.

The strong dollar has become a major headwind for U.S. firms that do business overseas. A strong dollar boosts the cost of U.S. exports, impacting U.S. competitiveness. A strong dollar also reduces the value of foreign revenues when translated back into U.S. dollars.

China's decision in August to devalue the yuan relative to the U.S. dollar reminded everyone about the lever a nation's currency can have on its economy. China is the world's No. 1 exporter, with 2014 exports totaling an estimated $2.25 trillion. No. 2 and No. 3 on the list are the European Union (about $2 trillion) and the U.S. (about $1.6 trillion).

Given how important exports are to China, it should have been no surprise that China's central bank, seeing its growth engine sputtering, would devalue its currency versus the U.S. dollar. A cheaper yuan means cheaper prices for Chinese exports (and more expensive prices for U.S. goods), thus providing China with a competitive advantage in the global marketplace.

The yuan devaluation in August, coupled with an already strong U.S. dollar, may have been the final chad to fall in favor of holding the fed funds rate at zero. Yellen knows that boosting interest rates at a time when central bankers around the globe are reducing rates and devaluing their currencies only boosts the appeal of holding financial assets in U.S. dollars. And with many multinationals already filling earnings conference calls with tales of woe about how the strong dollar is impeding business, we understand the hesitation of the Fed to exacerbate the currency wars. 

Of course, there is an investment lesson here. Investors who base portfolio decisions on whether and when the Fed raises interest rates are probably focusing on the wrong thing. The strong dollar, as well as other forces, could keep the Fed at bay until well into 2016, though the Fed's Oct. 28 statement said it would be considering a rate hike at its December meeting.

We advise a better approach to your portfolio focus on the market stock by stock, own your best ideas, and develop your macro picture based on factors that impact sustained market moves, such as corporate profits, inflation, and longer-term bond yields.

Indeed, currency wars and their impact on the Fed have created the financial version of Waiting for Godot, the absurdist literary classic (by Samuel Beckett) that should be on the nightstand of every Fed member.


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