The U.S. Dollar Index (DXY) has experienced a recent surge, reaching a significant level. Should it surpass this level, there could be potential consequences for the stock market.
The Strengthening of the Dollar
Over the past few months, the dollar has gained over 5% against a basket of currencies, reaching 105 on the DXY. This increase can be attributed to higher yields on U.S. government bonds, as inflation rates have remained stable. This attracts investors looking to acquire U.S. bonds, driving up the value of the dollar.
Impact on U.S. Stocks
A stronger dollar poses challenges for U.S. stocks. It diminishes the earnings companies generate when translating foreign sales back into dollars. Additionally, a stronger dollar reflects a preference for safe-haven investments as global economies struggle. These factors can exert pressure on U.S. stocks.
Limited Effect on Domestic Equities
Interestingly, the higher dollar has yet to significantly impact domestic equities. While the S&P 500 index has declined by approximately 1.5% since mid-July, this can be attributed primarily to profit-taking. Investors have seized the opportunity to sell after enjoying double-digit gains in the index this year, particularly due to one key risk. The delayed consequences of higher interest rates, intended to curb inflation, continue to ripple through the economy.
Resilience in Vulnerable Companies
Furthermore, the strength of the dollar has not deterred companies heavily reliant on foreign sales. Despite deriving around 60% and 50% of their sales outside the U.S., Caterpillar (ticker: CAT) and Micron Technology (MU) have observed respective increases of 16% and 13% since the start of the dollar’s ascent.
In summary, while the upward trajectory of the dollar raises concerns for the stock market, its impact has not been pronounced thus far. The resilience of domestic equities and companies exposed to a stronger dollar suggests the market remains steadfast amidst prevailing uncertainties.
The Dollar’s Potential Impact on Stock Market
The current ease that investors have about the strength of the dollar may soon be challenged as the dollar index approaches a crucial threshold. Although the dollar index has faced resistance around the 105 mark multiple times since late 2022, its inability to surpass this level suggests that the dollar may continue to fall short of recent peaks.
However, the situation could rapidly change if the dollar index manages to break above 105. Such a breakthrough would indicate a lack of sellers and potentially trigger a surge in buying pressure, propelling the index back to its multi-decade high of 112, recorded in October 2022. Even if this milestone is not reached, an appreciation in the dollar’s value could pose challenges.
The possibility of a stronger dollar becoming a headwind for stocks is a concern raised by Tom Essaye of Sevens Report. If the dollar gains strength, it could create obstacles for the stock market.
One plausible scenario for dollar gains lies in the widening gap between U.S. and foreign-bond yields, making U.S. bonds more attractive to investors. Currently, the 10-year Treasury yield stands at just over 4%, while the German bund yield is slightly above 2.7%. Should Germany’s economy weaken, potentially approaching recession territory, the 10-year bund yield may decrease, resulting in funds flowing into U.S. bonds and strengthening the dollar’s position. Moreover, economic weaknesses in other countries could prompt investors to seek stability in their portfolios by turning to the dollar.
Higher risks could be in store for stocks if the dollar continues to strengthen. It is crucial to closely monitor the currency’s performance.
To learn more, contact Jacob Sonenshine