According to market analysts, as long as the US dollar continues to strengthen against its rivals, the stock market will have a hard time stopping its slide and finding a bottom.
Global equities endured a battered week, with the S&P 500 just missing its lowest close of the year on Friday. At the same time, a key US dollar index soared to a two-decade high, with the greenback surging against competing currencies and triggering volatility in financial markets.
See: These 20 stocks in the S&P 500 slipped as much as 21.5% during another brutal week for the market
After the Fed hiked interest rates by 75 basis points on Wednesday, currencies such as the euro EURUSD,
British pound GBPUSD,
and Japanese yen USDJPY,
continued to fall while the US dollar index DXY,
on Friday rose to its highest level since 2002 and posted its biggest weekly rise since March 2020.
The pound fell to a 37-year low against the dollar on Friday, while the euro fell below $0.98 for the first time. En-Tank hit a fresh 24-year low before Japan said on Thursday it had intervened to prop up the currency’s value for the first time since 1998.
Non-US currencies need to stabilize before international stock markets can find a “permanent bottom,” according to Nicholas Colas, co-founder of DataTrek Research. Looking back, a strong dollar in turbulent markets since the early 2000s is a fundamental sign of market stress, Colas said in a recent statement.
Still, the relationship between a strong dollar and global market turmoil is a “chicken and egg problem,” said Brian Storey, senior portfolio manager at Brinker Capital Investments.
The dollar’s continued rally comes as investors abandon assets seen as risky as they seek safe haven on fears of a global recession. The greenback’s rise is also partly due to currency carry trades, in which investors borrow low-yielding currencies like the Japanese yen and convert them into high-yielding currencies like the US dollar to earn higher rates, analysts said.
The US overnight interest rate currently has a target range of 3% to 3.25%, while the Bank of Japan has kept interest rates negative.
“As the Fed tightens, fixed income yields and then US yields are rising rapidly and that’s drawing money into the US,” said Brent Donnelly, president of Spectra Markets. “Then there’s also a feedback loop where the higher yields make people nervous and sell stocks, which also leads to buying dollars as a safe haven,” Donnelly said.
The 5-year government bond TMUBMUSD05Y,
Friday’s yield headed for its highest level since November 2007, while 2-year yield TMUBMUSD02Y,
continued its climb towards a 15-year high.
See: A historic global crash in bond markets threatens the liquidation of the world’s busiest trades, BofA says
How Could the Dollar Rally Slow Down?
A pause in monetary tightening by the Federal Reserve could serve to slow the dollar’s rise. However, with inflation remaining hot and the Fed determined to fight inflation, that seems a long way off.
Fed officials signaled on Wednesday that they would tolerate a hard landing that could potentially send the economy into recession as part of their efforts to bring down inflation. The Fed forecasts that the unemployment rate will rise to 4.4% next year, which is 0.7% higher than the current unemployment rate. There has never been a situation in history where the unemployment rate has risen by more than about 0.5% without the economy going into recession.
“Until something collapses, probably in credit markets, the Fed will remain hawkish,” Donnelly said. “What eventually breaks this cycle will be explosions in credit and stocks that eventually cause the Fed to send a different message,” he said.
Some investors continue to hope for collective action from global central banks to stem the dollar’s rise.
“In the past, when this got uncomfortable, we would say that we can’t rule out a coordinated global effort by central banks to stop the dollar’s rise because it’s causing so many problems,” noted Mace McCain, president and chief investment Officer at Frost Investment Advisors.
McCain referred to the Plaza Accord, a joint agreement signed in 1985 by the world’s largest economies to devalue the US dollar against the French franc, German Deutsche Mark, yen and pound through interventions in foreign exchange markets .
In the current market environment, it may still be safest for investors to hold US dollar-denominated assets, although they should also prepare for the possibility that the global stock market or the dollar will stabilize at some point in the coming quarters, he said Brinker’s floor.
All three major stock indices ended the week with losses. The Dow Jones Industrial Average DJIA,
shed 1.6% over the past week to end Friday at its lowest level since November 20, 2020. The S&P 500 SPX,
fell by 1.7%. The Nasdaq Composite COMP,
fell 1.8% on the week.
Next week, investors will be eyeing the Personal Consumption Expenditure Index, a key measure of inflation, released on Friday.