By Taylor Tepper
August 31, 2016

Federal Reserve officials have begun their seasonal dance that signals to investors that interest rates may soon rise.

Investors have responded in kind with an increased demand for the U.S. dollar, which has gained against a vast majority of major currencies over the past five days. With the Fed seemingly inclined to hike rates at least once this year, and the continued troubles in Europe and Japan, investors should expect more of the same. The U.S. economy appears to be the brightest light in a deep fog.

When you hear the phrase “strong dollar,” you might feel an inkling of happiness. After all, your transatlantic trip to Bordeaux just became that much cheaper. But there are real costs, too, which could affect your net worth. Here’s what you need to know.

Economics

Over the past five days the dollar gained 2.5% against the Japanese yen, and 1.1% against the euro and British pound in response to recent comments by Fed Chair Janet Yellen and other officials that hinted a rate hike may occur this year.

“In light of the continued solid performance of the labor market and our outlook for economic activity and inflation, I believe the case for an increase in the federal funds rate has strengthened in recent months,” Yellen said in a press conference at Jackson Hole, Wyo., last week.

In an interview on Bloomberg TV on Tuesday, Fed Vice Chairman Stanley Fischer said that the U.S. “is very close to full employment,” signaling that the Fed may be zeroing in on completing one of its two main responsibilities — maximizing employment. Employers added 255,000 new jobs in July, and an average of nearly 200,000 a month over the past three months. Meanwhile hourly wage growth hit 2.6% over the past year, which is well up over recent trends but trails pre-recession levels.

And people seem to be spending their paychecks. U.S. consumer spending jumped for the fourth consecutive month in July, putting even more pressure on the Fed to raise interest rates. “Of course, our decisions always depend on the degree to which incoming data continues to confirm the Committee’s outlook,” Yellen said in Wyoming.

However, the argument is not ironclad that the employment environment is doing well.

“There is a consensus view that the U.S. has reached full employment but that is ridiculous considering that broad measures of joblessness peg the actual jobless rate at 9.7% and this has barely budged in the past five months,” notes Gluskin Sheff and Associates chief economist and strategist David Rosenberg. That measurement of employment takes into account discouraged workers and those who are working part-time but would rather work full-time. Prior to the financial crisis, the same measurement put unemployment at 8.4%.

If the Fed believes economic conditions merit a modest interest rate hike of, say 0.25 percentage point, the dollar will most certainly rise. The dollar index, which measures the strength of the U.S. currency, rose 5% in the two months leading up to Dec. 16, 2015, the last time the Fed gradually increased rates.

Investments

What does this mean for your investments? Well, it’s complicated.

American multinational corporations, like the ones that make up the S&P 500, had a terrible start to the year, in part due to the effects of the strong dollar. Apple, IBM, and others reported weak earnings largely because their exports were suddenly more expensive, and thereby less competitive, than international rivals.

The S&P 500 endured the worst start to a year in its history and millions of Americans were looking at their 401(k) statements with dread. Just for some perspective, in the four months ended Jan. 20 the Schwab S&P 500 Index Fund


SWPPX
0%

dropped 7.1%.

To be fair, a strong dollar wasn’t the sole driver of this decline, but certainly was a significant factor.

If the Fed raises rates in September, or December, will something similar occur? Who knows?

Ostensibly the Fed will raise rates because they think the economy is strong enough to support an increase. If the economy is strong, then corporate earnings, on the whole, should perform well.

But no one can be sure. One consequence of the Fed taking unprecedented actions to palliate a once-in-a-lifetime financial crisis is that the central bank will have to take unprecedented actions to unravel those unprecedented actions.

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