Key takeaways
Large investors employing “carry trade” strategies got squeezed in August when the U.S. dollar lost ground to Japan’s yen, which contributed to a short-lived global equity selloff.
The yen’s rally was tied to Japan’s central bank raising interest rates earlier in the summer, its first rate hike in 17 years.
This episode largely represents a technical matter versus a problem with market fundamentals.
Currency fluctuations can, from time-to-time, have a significant capital market impact. For most of 2024, currency markets were relatively stable. The dollar’s value against the euro moved within a narrow trading range, and by mid-September, the two currencies’ relative value was close to where it started the year.1
“The fundamental factor contributing to currency trends was about central bank interest rate policy,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “Earlier in the year, the European Central Bank initiated interest rate cuts, while the U.S. Federal Reserve (Fed) delayed cuts.” In mid-September 2024, the Fed finally implemented its first rate cut of the current cycle, cutting the federal funds rate from a top level of 5.50% to 5.00%.
“Markets clearly anticipated the Fed was ready to start cutting rates,” says Haworth, noting the dollar’s sharply weaker move in the third quarter. “Central bank policy in Europe and the U.S. will likely influence currency trends going forward.”
More consequential pricing activity occurred in mid-2024 involving the dollar and Japan’s yen. While other central banks around the world contemplated interest rate cuts, the Bank of Japan (BOJ) was in a different position, with rates already near 0%. The yen rallied in late July in response to the BOJ raising interest rates, its first rate hike in 17 years. It led to a dramatic but short-lived stock market decline. While the yen continued to gain strength, it, like the euro, is at a similar point compared to where the dollar was at the start of the year.1
Sudden appreciation in the yen affected large investors using “carry trades” – in this case borrowing money in Japan to capitalize on its low interest rates, then using the funds to buy securities in the U.S. after converting yen to the dollar. The dollar’s sudden loss in value compared to the yen reduced potential carry trade profits. Investors using this strategy had to rapidly sell equity positions to meet their loan obligations. This triggered a short-lived global equity selloff.
It illustrated how investors utilizing currency trades must be aware of associated risks. Is the market vulnerable to a similar event? “Nobody knows for certain,” says Haworth. “To this point, there’s been no dramatic currency move to bring it on.” Haworth adds that the circumstances leading to early August’s problems were unusual. “The Bank of Japan held 10-year interest rates below 1%, an unusual situation that doesn’t exist elsewhere.”
Year-to-date, the dollar is nearly flat versus the euro.1 As indicated in the chart below, year-to-year changes in dollar-to-euro values have been more muted in recent times compared to the past decade.
“Relative currency values reflect the global flow of funds,” says Haworth. “When the dollar strengthens, it means more foreign money is flowing into the U.S. than the other way around.” In 2023, investors perceived that U.S. interest rates were near a peak while still rising in other countries. As a result, more money flowed out of the U.S. This led to a moderate decline in the dollar’s value versus the euro.1
Haworth says many factors can affect currency movements. “On the face of it, higher U.S. rates should boost the dollar,” says Haworth. “On the other hand, U.S. government deficit spending is on the rise. This means the U.S. Treasury must issue more debt, and an increasing supply may mean foreign investors become less attracted to owning U.S. Treasury debt.” Investors may want to consider the role of currency trends when positioning portfolios.
As recently as 2008, it took nearly $1.60 to purchase the equivalent of one euro. The dollar has gained significant strength since that time.1 But as is often the case with currency markets, the gradual improvement occurred with a great deal of fluctuation along the way.
“Relative currency values reflect the global flow of funds,” says Rob Haworth, senior investment strategy director at U.S. Bank Wealth Management. “When the dollar strengthens, it means more foreign money is flowing into the U.S. than the other way around.”
Starting in early 2022, the Fed embarked on a series of significant interest rate hikes intended to curb inflation. The result was improved demand for dollars, boosting the dollar’s value versus other currencies. In the summer of 2022, the dollar reached parity with the euro ($1 = one euro). For a brief time, less than $1 was required to purchase one euro. Prior to that time, this last time parity occurred was in late 2002. In 2023 and 2024, the dollar has generally been in a trading range between $1.06 and $1.120 to the euro.1
Trends occurring in the dollar’s relationship to the euro have generally tracked with other currencies as well. One measure of this is the Nominal Broad U.S. Dollar Index. It measures the dollar’s value to a basket of other global currencies, based on their relative importance to U.S. import and export activity.
In late September 2022, the index reached a recent all-time high of 128.32, reflecting significant U.S. dollar strength versus other currencies across the globe. The index dropped to less than 118 as recently as July 2023 before reaching a 2023 peak of more than 124.00 in late October 2023. In late 2023, the dollar, as measured in the index, again fell below 120, but in 2024 stayed above that level.2
It should be noted that currencies fluctuate constantly. Changes are typically minor on a day-to-day basis, but trends may develop with potentially significant implications over time.
A positive feature of a stronger dollar is the lower cost of imported products from other countries. For example, if a car made in Germany is valued at €50,000 and then is imported to the U.S. when the dollar stands at $1.20 to €1, the retail price of the car in the U.S. would (theoretically) be $60,000 (20% more than its European price to reflect the currency exchange rate). If the dollar were to appreciate to $0.90 to €1, the car’s value in the U.S., using the same assumptions, would decline to $45,000, a significant savings for a U.S. consumer.
However, a strong dollar can also detract from revenues generated by multinational companies based in the U.S. The net income earned from foreign sales will decrease once exchanged into dollars. A stronger dollar means U.S. companies that export products abroad will be less competitive because the price of the product translated into euros or another currency is higher, which can lead to lower sales as foreign buyers shift to lower cost alternatives. The impact on the bottom line for companies trading overseas may be limited, however. “They have tools to adjust currency risk, such as locating production facilities in countries where they do business, or using currency hedging strategies to offset any unfavorable currency movements,” says Haworth.
Haworth says the impact of currency movements shouldn’t be a major consideration for investors as they assess the value of specific stocks. The same is not true, however, for U.S. investors who include overseas-based investments in their portfolios.
For example, consider the value of an investment in the MSCI European Union (EU) Index. Year-to-date through September 19, 2024, the index, in local currency terms, generated a return of 11.04%. However, the net return for a U.S.-based investor in the index, translated back into dollars, was just 9.14%.3 In other words, the slightly stronger dollar resulted in a modestly lower net return for a U.S investor in overseas markets. By contrast, when the dollar weakens compared to the euro, it enhances the net return for U.S. investors after the currency exchange.
“Currencies are less volatile than stocks as a whole, and their direction is challenging to predict, given numerous factors that influence relative currency values,” says Haworth. “Equity investors, in particular, should be somewhat insensitive to short-term dollar trends when positioning long-term investment assets.”
Currency trends are difficult to predict. Haworth says the dollar has benefited from U.S. economic strength relative to most other developed countries. Yet he notes there may be potential headwinds ahead. “Depending on the election outcome, we could see more significant tariffs implemented. Federal government deficits are on the rise as well. Both factors could weaken the dollar.” Haworth points out that foreign buyers today play a lesser role in the U.S. Treasury market another factor potentially pressuring the dollar’s value versus foreign currencies.
While currency considerations may not play a decisive role in your investment strategy, the issue could be worth discussing with your wealth management professional, particularly if your portfolio includes overseas investments. It can be beneficial to account for the ways currency trends might impact your investments and potentially influence how you choose to allocate assets within your portfolio in support of your investing strategy.
In 2023, the dollar declined modestly compared to the euro, Europe’s common currency. At the start of 2023, the dollar was at $1.07 to the euro, but fell to $1.1062 by year’s end. It recovered modestly in 2024’s opening months, dropping near $1.06 to the euro in April, though the dollar retreated modestly since then. It is notable that in August, 2022, the dollar reached parity with the euro ($1 = 1 euro).1 As is always the case, currency values can be expected to fluctuate over time.
While currency values fluctuate constantly, between 2008 and 2022, the general trend was toward a stronger dollar. As recently as 2008, $1.60 was required to purchase one euro. In August 2022, the dollar reached parity with the euro ($1 = 1 euro). For a brief time, it took less than $1 to purchase one euro. In later 2022, the dollar began giving up some ground, and by the end of 2023, the exchange rate was $1.1062 to the euro. The dollar regained some ground in early 2024, but in mid-September was back above $1.10 to the euro.1 From a historical perspective, the dollar and euro remain fairly close to parity.
Currency valuations fluctuate constantly, driven by the flow of funds between markets. The two biggest drivers are central bank policies (interest rates set by the U.S. Federal Reserve and its counterparts in Europe, England, Japan and elsewhere); and economic growth relative to inflation. Those factors often dictate which way money flows. If attractive interest rates and economic conditions in the U.S. draw foreign investors, the dollar is more in demand and gains strength. If, by contrast, other countries have more attractive interest rates and more favorable economic conditions, it will likely be reflected in their own currencies gaining strength and the dollar weakening.
The yield curve between 2-year and 10-year Treasuries is no longer inverted after more than two years.
The U.S. Bank Asset Management Group is optimistic about consumer and business spending in the second half of the year, with companies continuing to prioritize shareholders through stock buybacks and dividends.
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