The U.S. dollar has showcased significant strength this year, outpacing many foreign currencies. From January to mid-October, it appreciated by 13 percent against the euro, 22 percent against the Japanese yen, and 6 percent against various emerging market currencies.
While the dollar’s rise against emerging market currencies was less pronounced than its gains against Europe and Japan, it was particularly harsh for those countries. Many emerging economies—such as Sri Lanka, Zambia, Pakistan, and Turkey—that have dollar-denominated debts are now facing challenges in repaying these obligations with local currencies that have depreciated in value.
Perhaps we are seeing the peak of the dollar’s rapid ascent. Over the past month, the dollar has begun to decline from its 20-year high, as indicated by the dollar index.
As of now, the dollar index is up more than 10 percent year-to-date, yet it has experienced a decline of over 3 percent in the last 30 days.
Following a dip to below 96 cents in September, the euro has bounced back to nearly $1.04. Similarly, the British pound has also recovered from its recent low, and the Japanese yen is seeing a slight improvement after hitting a 32-year low against the dollar.
Questions linger about whether the Federal Reserve has successfully managed inflation. Can the Fed now step back from aggressive interest rate hikes and make a shift in 2023? Is the U.S. economy starting to falter?
An impression is taking shape in the currency markets that the Fed may opt for a 50-basis point hike in December instead of the anticipated 75-basis points, leading to speculation that inflation may have peaked and that monetary easing may be on the horizon.
However, this may merely be a temporary downturn in the dollar’s strength, leaving the future uncertain.
Pause Before Pivot
While consumer price inflation may have peaked, returning to the Fed’s target of 2 percent is likely to be fraught with surprises along the way. The journey down will entail volatility and challenges.
Fed Chair Jay Powell has learned from the fluctuating inflation of the 1970s. He understands how rapidly inflation can resurge if the Fed fails to act decisively. He is wary of acting too soon, as he wants to avoid a repeat of a prolonged inflation crisis.
The current federal funds rate is situated in the range of 3.75 to 4.00 percent. A 50-basis point increase in December will adjust this to between 4.25 and 4.5 percent. However, this is not the final destination. Recently, St. Louis Fed President James Bullard indicated that further hikes are necessary:
“To attain a sufficiently restrictive level, the policy rate will need to be increased further.”
During his presentation, Bullard asserted that the federal funds rate should be between 5 and 7 percent to be considered adequately restrictive. However, analysts at Stifel, Nicolaus & Co. suggest that a rate of 8 to 9 percent may be necessary.
This signifies that the Fed needs to increase rates by an additional 1 to 3 percent to meet Bullard’s criteria. Furthermore, once the Fed reaches this target rate, it is unlikely to pivot quickly, contrary to expectations from many in the market. Instead, they will pause to allow these restrictive rates to exert their influence on the economy.
High interest rates, particularly in comparison to the last two decades, are expected to remain for several years or potentially longer. Any attempts to lower them prematurely, as inflation appears to wane, could result in inflationary flare-ups.
Consumer price inflation, much like historical challenges, won’t simply fade away. Errors in addressing it could extend the period of elevated interest rates throughout the decade.
Price Recalibration
In essence, the coming pause will serve as a period of price recalibration. Assets heavily reliant on credit, such as residential real estate, will likely be repriced downward to account for increased borrowing costs. Business loans will be strategically allocated to ventures that genuinely generate profit.
Companies focusing solely on growth without substance may not survive. They will need to adapt or risk becoming obsolete.
The era of cheap liquidity is transitioning to one of costly capital. This shift is already evident; as noted several weeks ago, funding for collateralized loan obligations (CLOs) has decreased by 97 percent from last year’s figures.
Going forward, net income post-tax will serve as the crucial metric. How much are businesses truly earning, and what can they realistically reinvest to foster growth?
Those enterprises that survive and flourish will be those capable of self-sustainability through their own contributions. Financial maneuvers like leveraging cheap credit for buybacks will no longer be viable.
Educational institutions, long the beneficiaries of cheap credit, may need to reconsider their inflated tuition fees to attract talented students. Meanwhile, various indicators suggest that the economy may be nearing a standstill.
For instance, the price of a barrel of West Texas Intermediate (WTI) Crude oil has decreased below $78, plummeting from over $120 in June—a drop of over 35 percent in just five months.
Additionally, the World Bank’s Fertilizer Price Index indicates that fertilizer prices have fallen over 15 percent since April, although they remain nearly 25 percent higher than last year.
So, what should investors consider doing?
Gold Shines Bright
At this juncture, the key questions regarding inflation containment or potential pivots by the Fed seem secondary. The repercussions of rising interest rates have already occurred.
This “damage” could effectively correct decades of misguided monetary policy, bringing long-absurd price distortions back in line.
For investors focused on capital accumulation and wealth building, this is a precarious time filled with risks but also budding opportunities.
The S&P 500 has declined by roughly 16 percent year-to-date, and the NASDAQ has plummeted over 28 percent during the same period. Will a year-end rally materialize?
Historically, stocks remain overvalued; the Cyclically Adjusted Price Earnings Ratio (CAPE) for the S&P 500 is still above 29, just shy of its valuation prior to the catastrophic 1929 market crash and the onset of the Great Depression.
Consequently, it might be premature to invest broadly in stock market indexes. However, numerous individual stocks offer excellent value and dividends, making them intriguing options at current prices.
Moving into the next 6 to 12 months, prioritizing the return of invested principal may take precedence over the desire for returns on that principal for prudent investors. The rise in interest rates has made U.S. Treasuries a more appealing option.
A friend recently informed me that Schwab was providing a 5 percent return on a 1-year Treasury note—a stark increase from around 0.4 to 0.5 percent at the beginning of 2022.
While 5 percent may not constitute an extraordinary return—and will likely yield a real loss when adjusted for inflation—it does offer the advantage of principal security with interest at the year’s end. This contrasts sharply with the unpredictable outcomes of investing in the S&P 500.
Ultimately, the real opportunity lies in tangible assets—specifically, gold. Recently, as the dollar index has seen a decline, the price of gold in dollar terms has surged. On November 2, gold was priced at just over $1,615; it has now risen to nearly $1,750 per ounce—an increase of over 8 percent in just three weeks. This could signal the beginning of a significant upward trend.
From our perspective, this shift is overdue.
[Editor’s note: This period poses challenges for investors—factors like inflation, deflation, and recession are looming. Nevertheless, it may also mark the onset of considerable wealth creation over the next decade. We aim to navigate this journey effectively. If you are interested, consider exploring my Financial First Aid Kit, which contains essential information to prosper and safeguard your financial privacy as the global economy faces downturns.]
Sincerely,
MN Gordon
for Economic Prism
