TSP

Seoul, South Korea - Oct 2019: A currency trader works near screens showing the foreign exchange rate between U.S. dollar and South Korean won. At this point, having some I Fund exposure, either in a Lifecycle fund or with another weighting method, may be beneficial for long-term investors as part of a diversified portfolio.

Lyn Alden

During the past week, the large-cap C Fund increased 0.55%, the 0.68% small-cap S Fund increased 0.68%, and the international stock I Fund increased 1.25%.

Last week, I wrote about the U.S. Federal Reserve initiating a major change in monetary policy. For several years, the Fed has been able to maintain tighter monetary policy than the rest of the world, which played a large role in strengthening the U.S. dollar compared to most other currencies.

This month, however, the Fed announced a plan for more than $60 billion per month in liquidity injections and balance sheet expansion going well into 2020, which is a significantly looser monetary policy and, all else being weaker, may weaken the dollar.

Read More: Major Shift in U.S. Monetary Policy

After going up over the past several months, the dollar is down over 2% so far in October, and down more than 1% in the past week, compared to a basket of major currencies:

Chart Source: MarketWatch

The biggest currency weighting in this basket of currencies for comparison is the European euro by far, but the British pound sterling, Japanese yen, Swiss franc, Swedish krona, and Canadian dollar are also included.

When the dollar weakens, it gives a boost to the performance of international assets that are denominated in currencies that the dollar is weakening against, at least for dollar-denominated investors including TSP investors.

As an example, if European stocks are flat for a week in their local euro currency, but the dollar weakens by 1% compared to the euro during that week, then for U.S. investors that focus on dollar-denominated returns, their European stock holdings went up 1%.

In addition, large companies in the C Fund earn over 40% of their revenue from international markets. When the dollar is strong, those foreign earnings translate into fewer dollars, and when the dollar is weak, those foreign earnings translate into more dollars. So, a weaker dollar can potentially provide some beneficial currency tailwinds for large U.S. companies.

Smaller companies in the S Fund have less international exposure on average, and are more focused on the domestic U.S. market.

One of the biggest beneficiaries of a weaker dollar, if this trend continues, would likely be emerging markets. Many of those countries have large amounts of external debt denominated in dollars, so when the dollar weakens compared to their local currency, it acts as a partial debt jubilee for their governments or corporations.

The I Fund does not yet have emerging markets exposure, but has plans to add it in 2020, and if that plan is completed, emerging markets would make up about a quarter of the fund.

TSP investors that wish to diversify beyond the fund options in the TSP can use supplemental retirement accounts, such as an IRA, to invest in any asset classes that they wish in addition to their TSP holdings.

Five Decades of Cycles

Looking back over the past five decades since the dollar was removed from the gold standard, the U.S. dollar has had three major cycles of strengthening and weakening, each lasting about 15 years. In these major moves, the dollar strengthened or weakened against a basket of major currencies by 25-50% or more. Various smaller cycles have seen approximately 10% changes up or down as well:

Chart Source: St. Louis Fed

Holding international stocks when the dollar is going up compared to foreign currencies has historically been painful for U.S. investors. However, holding international stocks when the dollar is going down has historically been very lucrative.

We have been in a strong dollar environment for the past five years, since late 2014. It seems likely that this pivot from hawkish monetary policy to dovish monetary policy by the Federal Reserve may be turning this cycle down once again to a multi-year period of a weaker dollar, but nothing is for certain. The dollar index broke below all major moving averages in the past couple of weeks since the Fed announced it would expand its balance sheet this month.

I moderately increased my international exposure this week, but more towards emerging markets than developed markets like the I Fund has. However, a weakening dollar environment, if that is what we are entering, is also the best chance for the I Fund to shine relative to the C Fund or S Fund like we saw this week.

At this point, having some I Fund exposure, either in a Lifecycle fund or with another weighting method, may be beneficial for long-term investors as part of a diversified portfolio.

Lyn Alden is a financial writer and an engineer, and holds a bachelor’s in engineering and a master’s in engineering management, with a focus on financial modeling and resource management. She specializes in analyzing and presenting financial data. Her investment work can be found on LynAlden.com.

See also, Is the I Fund Cheap Enough Yet?