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Dollar Rally: Causes and Potential Market Consequences

· Economics,Currency,United States

Dollar Rally: Causes and Potential Market Consequences

The ICE Futures U.S. Dollar Index (ticker: DXY) has rallied over 33% since March 2018. The Index tracks the appreciation of the U.S. Dollar (USD) against six foreign currencies: the European Euro, the Japanese Yen, the British Pound, the Canadian Dollar, the Swedish Krona, and the Swiss Franc.

The USD-Euro exchange maintains approximately 57% of the index, signaling that the dollar’s relative strength against the Euro is underlying the recent index run. The weakness in the Euro has, in part, been catalyzed by Euro zone short-term nominal interest rates remaining at or close to zero; conversely, U.S. treasury rates remain comparably high. The DXY is correlated with rising U.S. rates: international investors’ purchases of higher yielding U.S. securities are facilitated by corresponding purchases of USD, increasing demand for the U.S. Dollar relative to home-country currencies.

The depreciation of the Euro has adversely affected U.S. firms that derive significant revenue from Europe. Because the dollar has become relatively stronger, exports to Europe have diminished in value. This trade imbalance is a consequence of the international currency flows fundamentally affecting nominal exchange rates. The effects of diminishing export revenues are manifesting in market index outcomes. The Russell 2000 index (ticker: IWM) of small-cap stocks, many of which lack significant international exposure, is a 2019 relative outperformer compared to the Dow Jones Industrial Composite (ticker: DIA) which contains mature exporters such as McDonalds (ticker: MCD) and Boeing (ticker: BA). While rising dollar appreciation may be neutral for smaller-cap companies, the adverse effects of a strengthening dollar are shown by larger exporters’ earnings. Further appreciation of the dollar could signal a tumultuous period of equity market decline, as U.S. exporting firms may fall short of international earnings projections. Additionally, dollar appreciation could have a compounding negative effect on dollar denominated commodities. Though commodity prices have largely mirrored recent DXY movements, a further strengthened dollar could restrict international investment in commodity markets.

A strong dollar remains a significant barrier to a continued U.S. equity market rally. Geopolitical events and monetary policy often define currency market movements. Chinese and European trade negotiations, Euro zone nominal interest rate movements, and U.S. federal funds rate adjustments notably stand to affect the relative strength of the dollar in the foreseeable future. These events and policies will not only explain nominal exchange rate developments, but will also inform market sentiment and influence market outcomes.

Written by Aaron Rennert, Edited by James Mueller & Alexander Fleiss

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