U.S. equity markets may take their cues from the dollar, as currency markets have been the preferred vehicle for investors looking to express an opinion on policy developments.Kim Hong-Ji
The S&P 500 has a friend and a foe in King Dollar.
The greenback is the only major currency whose current strength has coincided with rallies in its domestic equity market, according to Goldman Sachs Group Inc., underscoring the risk for stocks if the U.S. dollar's poor start to the year gathers more steam after a strong performance following the U.S. election.
"Recently, the dollar is alone as a major risk-on currency, gauged by looking at the rolling correlation of [the] S&P 500 and the U.S. dollar," writes a team led by Ian Wright.
This phenomenon is all down to U.S. president-elect Donald Trump, the analysts say, who recently said that the greenback is too strong. Enthusiasm about the prospects for a U.S. expansion under the new administration have fuelled a rise in real rates, buoying the dollar, while these heightened growth expectations have also supported equities.
"We view the strong U.S. dollar and strong U.S. equity market as coming largely from the same risk factor – growth and fiscal policy optimism following the Trump election," they write. "This has driven both U.S. equity market multiple expansion and more reflation and Fed repricing."
U.S. equity markets may take their cues from the dollar, as currency markets have been the preferred vehicle for investors looking to express an opinion on policy developments.
But risks for the currency-fuelled stock rally loom. While U.S. stocks have tread water over the past two weeks, it has been a rough start to the year for the dollar, raising the risk that equities could soon catch-up with their currency counterpart. The Bloomberg Dollar Spot index, which tracks the greenback against 10 of its peers, is off by 2.2 per cent from its postelection peak.
With scant details so far on U.S. fiscal-stimulus plans, Kit Juckes, global strategist at Société Générale SA says there's a "real dearth" of drivers to continue the greenback's uptrend.
"It evokes memories of a year ago when the market got bullish [on the] dollar after the first Fed hike of the cycle, but the dollar subsequently traded lower into May after global market turbulence early in the year cut off Fed rate expectations at the knees," he wrote in a note on Tuesday.
A Merrill Lynch survey of equity market investors conducted this month has another warning for dollar-fuelled equity bulls. Some 47 per cent of respondents say long dollar positioning is the most crowded trade in global markets, followed by government bond shorts. A net 22 per cent of respondents also say the greenback is overvalued, the highest level since November, 2006.
Fund managers, with combined assets under management of $455-billion (U.S.), said Treasury bond yields should be the biggest driver for global equity markets over the next six months, followed by the dollar, underscoring the risk of reversal in sentiment if the greenback's loss of momentum endures.
There's still another risk for equity investors: What has been good for stocks – dollar strength – is generally bad for the rest of the world.
While the dollar's appreciation has fed risk appetite in U.S. stock markets, the rest of the world is reeling from the rising greenback. The Bank for International Settlements crowned cross-currency basis swaps – which reflect the cost to procure the U.S. currency – as the world's chief fear gauge to watch, as a rise in the dollar in recent years has triggered a slowdown in risk appetite among global banks, reflected in contraction in credit growth.
So while U.S. markets are greeting dollar strength with a "risk-on" attitude, the rise in the currency contributes to a "risk-off" environment for real activity around the globe.