Currencies are not easy to understand. Similar to stocks, they often trade at levels inconsistent with fundamentals. In addition, many traders 'pile in' to carry trades, borrowing at low rates in one currency to invest in another at a higher rate. This can add to extreme pendulum swings. In the current moment, risk in the market environment has increased because of strong moves in many currencies. The decrease in oil has hurt emerging markets and the fall in their currencies has raised risks because developing countries make up over 50 percent of world growth.
Given the complexities, let's not focus on how currency markets operate and instead focus on why they matter.
Let's take the Russian ruble for example. The Russian ruble has fallen to the lowest level ever against the dollar. This is not a coincidence as oil prices have dropped from $110 a barrel to $26. The Russian government generates roughly half of their revenues from the oil and gas sector and would need oil at $82 per barrel to balance their budget.
From here, with the ruble down, worries abound about what Russia will do to balance their budget and stem the free fall of their currency. Inflation is currently over 10 percent and poverty runs almost 15 percent. This a real concern. Russia cannot single-handily move oil prices higher. What destructive measures might they take?
The US dollar, being more valuable relative to other curriences, means goods and services are pricier for companies operating in the US, relative to other countries. For example, in 2012, one Mexican peso equaled 0.075 US dollars. Fast forward to today, one Mexican peso equals 0.054 dollars. Simply put, one peso can buy less dollars today than in 2012 because the dollar has strengthened.
The difference appears small, but the impact is large. Let's say Company X manufacturers dog leashes in the U.S. and sells them in Mexico for $15. In 2012, a Company X leash would have cost 200 pesos; today it would be roughly 277 pesos, a 38.5 percent increase.
What does this mean for the everyday U.S. investor?
First, do not trade currencies or make portfolio allocations based on currency research.
Secondly, there are international investing risks where currencies are involved. Currencies from countries dependent on oil (ex. Brazil, Russia) are falling. Many of these countries are considered ‘emerging markets.’ Thus, the ‘emerging markets’ allocation in portfolios have been under pressure.
Lastly, U.S. manufacturers are under pressure from a stronger dollar. Their goods are more expensive causing demand to decrease. If you work in manufacturing, you might experience that pressure first-hand, especially if you deal across borders. But for others, if you own dollars and transact in dollars, the impact is minimal.
The repercussions for the everyday American are limited, but the impact on companies is tremendous. It is important to be aware.