US Dollars may protect your investments

8 May 2024
USD offering protection

The 60/40 portfolio has long been an investor favorite, and for good reason. Over the past two decades, bonds performed well when stocks didn’t, so owning a healthy mix of both (60% stocks and 40% bonds) resulted in a more balanced portfolio with higher risk-adjusted returns.

But the pandemic changed that. Sky-high inflation and interest rates rattled both stocks and bonds in 2022, leading the 60/40 portfolio to suffer its biggest losses in the past 100 years.
Now, inflation has calmed down since then, stocks are handling high interest rates well, and bonds could benefit from falling interest rates. Having said that, inflation could prove more volatile than hoped, and the threat of higher-for-longer rates hasn’t disappeared.

So in such uncertain times, it might be wise to diversify beyond the traditional. Commodities are one option: if an inflation reboot is caused by a strong economy, commodity prices should increase in line with higher demand. But if the economy suffers under higher-for-longer inflation, demand for goods would likely waver and that strategy could backfire.

That’s where the US dollar comes into the picture. As shown in the chart below, the dollar index “DXY” – a measure of the value of the USD against a weighted basket of currencies – often does well when stocks and bonds start moving in tandem with each other. The bottom-right quadrant indicates that when stocks and bonds are highly correlated, the DXY tends to move in the opposite direction. Since 2022, the US dollar has worked exceptionally well as a hedge for the 60/40.

USD protection

The US Dollar can effectively hedge the 60/40 portfolio when bonds lose their diversification benefits to stocks (bottom-right quadrant). Source: Goldman Sachs

Besides the dollar’s reputation as a safe haven when stocks and bonds fall into lockstep, there’s another reason why investors have been backing it. The US economy has been outperforming others, prompting the Federal Reserve to hike interest rates faster and – as it stands – keep them higher for longer than other central banks have. This process makes US assets more rewarding, and that attracts more investors toward the dollar, bumping up its value.

So to make a 60/40 portfolio more robust, holding US dollars may not be a bad idea. Of course, there’s no guarantee it will keep rising, but that’s the price to pay for the added protection.

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