The dollar and stocks, has the relationship changed?

For most of this year, the dollar rallied as stocks sold off. However, the dollar has soared this week against its G10 peers, and the dollar index is now at its highest level for a month. Just when we thought that we could rely on a correlation to try and make trading that bit easier for us, the dollar has reared its mighty head to remind us that it is still King, regardless of what the stock market is doing. Thus, as the summer stock market rally regains its poise after losing its way earlier this week, the dollar is moving higher with it. Below, we look at the reasons for the dollar’s rally and we assess if it can continue to move higher at the same time as US stock markets.

1, Hopes for the Fed

This week’s FOMC minutes, from the Fed’s July meeting, offered some hope to the doves. While the Fed still sounded absolutely committed to tackling inflation, they also said that they could adjust the size of rate hikes depending on the data at hand. Thus, 75bp rate hikes are not necessarily to be expected going forward. The market has digested this information and has taken this as a reinforcement of the Fed’s message from its July meeting that it could slow its pace of rate hikes. Currently, the market is pricing in a 60.5% probability of a 50 bp rate hike in September, roughly stable on the week, with a 39.5% chance of a 75bp rate hike. The market is now expecting the Fed to move to a more dovish stage of the rate-hiking cycle, although 50bp rate hikes are not to be sniffed at. Although rate hikes can be good for a currency, the dollar is likely to benefit from a potential slowdown in the pace of the Fed’s hiking cycle as it boosts the chances of a soft economic landing for the US. The risk for the dollar when the Fed was hiking rates by 75bp, was that it would tip the US economy into recession. A recessionary environment is not good for a currency. Thus, the shift in the Fed’s tone suggests that we could be entering a “goldilocks” phase for the dollar right now, and this may help to push up the dollar index back to its 108.70 highs from mid-July.

2, Engineering a soft landing

This week has cemented the view that the US economy can withstand the recent Fed rate increases and the US central bank can engineer a soft landing for the US economy at the same time as bringing down inflation. Last week’s fall in US inflation was a catalyst for sparking the idea that a soft landing was possible, after many thought that it was unachievable a few weeks ago. This has helped the S&P 500 to rally some 17% since June, and Apple is now a mere 7% away from a $3 trillion valuation, last reached back in January. The jobs data is still strong, gauges of consumer sentiment are picking up and on Tuesday Walmart reported that households’ spending at their stores rose strongly, with Q2 revenues up 8.4% on the year. Thus, this market rally is underpinned by good economic news. The fact that, aside from some crypto casualties, there has not been a rise in bankruptcies or other financial blow ups, and the market is willing to look at the recent rout for stocks in the first half of the year as a shake-up of the market that was needed after valuations were stretched. We have mentioned in previous notes, that this shake-up was essentially a recession in stock market valuations, rather than a sign of economic pain to come, even though the US economy is in a technical recession. Overall, this is driving the stock market higher. With the Fed in data-watching mode, whether this rally will continue could depend on how the economic data pans out. If we have seen the peak for inflation in the US, and US economic data surprises on the upside, then we could see the stock market rally continue. This could also boost the dollar.

It is worth pointing out that as we near the end of the Q2 earnings season, the energy sector was the largest contributor to earnings growth for the S&P 500 last quarter. If the energy sector was excluded from Q2 earnings averages for the S&P 500 then the index would be reporting a YoY decline in earnings of 3.7%, rather than a YoY increase in earnings of 6.7%, according to FactSet. Given the sharp decline in the oil price in recent weeks, we will be watching the outlook for the energy companies closely, to see if they can continue to prop up the S&P 500 earnings reports. However, if the economic data picks up from here, especially data around consumer sentiment and consumer spending, this could be good news for future earnings for the S&0 500 ex the energy sector.

3, Bad news for the euro

The other side of the FX coin that could help to propel the dollar higher on a broad basis is that other currencies in the G10 and beyond look weak. The pound is hindered by the UK’s stubbornly high inflation rate that is darkening the growth outlook, some EM currencies look untradable right now, while the euro has also been slammed this week. EUR/USD is down below $1.01 and looks to be heading back to parity. The news got worse on Thursday, after European natural gas futures surged to another record high, suggesting that the energy supply crunch continues to batter the region and could have big economic ramifications as we move into the winter months. Germany expects local gas shortages this winter, with households and industry impacted. Europe is now battling with Asia for LNG supplies, which is also pushing up prices. The US’s position as a net energy producer, means that it is in a better position that Europe and Asia when it comes to the procurement of energy. Although the US is also exposed to international prices for energy, there are unlikely to be any supply issues in the US this winter, which could protect the economy, and ultimately boost the dollar vs. the euro in the medium term. Thus, we expect parity to return, sooner rather than later.