by SignalFactory · February 21, 2020 | 08:26:25 UTC
Here’s
a market conundrum: A surging dollar doesn’t appear to be putting the brakes on
an equity rally that’s pushed major U.S. indexes to all-time highs despite some
periodic volatility tied to worries about China’s COVID-19 epidemic.
A
rapidly strengthening U.S. dollar can be a source of discomfort for
stock-market investors for a few reasons. Most obviously, a stronger currency
can make U.S. exporters less competitive overseas and dent overseas earnings
for U.S.-based multinationals.
Beyond
earnings, a stronger dollar also represents a de facto tightening of monetary
policy, noted Russ Koesterich, portfolio manager at BlackRock, in emailed
comments.
“If not offset by other factors, this can lead to a broader
tightening of financial conditions, which in turn can result in multiple
compression and heightened volatility. Tighter financial conditions are also
likely to negatively impact other risky assets, notably emerging markets,” he
said. Multiple compression occurs when a company’s earnings rise but its stock price
stays the same or falls, reducing the price-to-earnings ratio.
The
ICE U.S. Dollar Index DXY, -0.09%, a measure of the U.S. currency against a
basket of six major rivals, rose 0.1% to 99.577 after hitting an intraday high
at 99.72, according to FactSet, taking out its early October high to trade at
its strongest since May 2017. For the year to date, the index is up 3.4%, so
far defying consensus expectations for a 2020 decline.
A
stronger U.S. currency eventually “could present a headwind” to stocks, but it
would likely take a further run-up, said Liz Ann Sonders, chief investment
strategist at Charles Schwab, in a phone interview.
Of
course, it isn’t so simple to determine what magnitude of dollar rally would
put a dent in stock-market sentiment, Sonders said, but she noted that a more
recent episode of dollar-related equity weakness came after a much sharper
currency rally.
In
2014-2015, the dollar index jumps around 27% in around 10 months, with the
gauge further extending gains in 2016. Stocks sold off as the dollar rally took
a toll on earnings, particularly in the energy sector, where a rising dollar
also contributed to weakness in oil prices, Sonders noted.
The
current rally is more subdued. The index has rallied around 12% off its
February 2018 low to its present level.
Koesterich
noted that the dollar index also saw a bigger jump in mid-2018 when it rallied
by over 8%. Stocks tumbled sharply in the fourth quarter of 2018 before
rebounding sharply last year.
Moreover,
the dollar index’’s rise still hasn’t taken it far outside the range that’s
prevailed over the last 18 months or so. “This suggests that it will arguably
take a more dramatic rise in the dollar to impact equity markets,” he said.
The
dollar and equity gains have also accompanied gains by traditional haven
assets, including gold and Treasurys. Indeed, gold futures GCJ20, +1.06% were up 0.3% on Wednesday and have rallied
5.7% so far this year. A stronger dollar is often seen as a negative for gold
and other dollar-priced commodities, making them more expensive to users of
other currencies.
Some
market watchers, meanwhile, argued against the notion that the dollar itself is
benefiting from haven-related buying around China’s COVID-19 outbreak. In a
Tuesday note, analysts at RBC observed that rather than rallying when equities
and other such “risky” assets come under pressure, the dollar is showing a more
positive correlation with the stock market than at any other time in the past
two years.
Moreover,
the dollar’s overall price action is actually at odds with other more
traditional havens, such as gold and Treasurys, which have both gave back some
of the ground attributed to flight-to-safety buying, said Jason Draho, head of
the asset allocation for the Americas at UBS, in a note.
“The most plausible explanation for ongoing dollar strength is
that investors globally want to own U.S. assets because they have the highest
confidence in the U.S. economy doing fine, which is more of a flight-to-conviction,
not safety,” Draho said.
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