Monday’s break above 87.00 in the dollar index was a pivotal moment for the buck, as it broke through a 30 year downtrend. This technical breakthrough signals a new era for the dollar, and we could be at the start of a major dollar uptrend.
Since the dollar is the world’s most important currency, it is one side of nearly 90% of all FX transactions, according to the Bank for International Settlements Triennial survey for Foreign Exchange, this major shift in the buck will have major implications for financial markets. Below we take a look at the fundamental impacts and what it could mean for future Fed decisions, and also the impact a strong dollar could have on the equity and commodity markets.
Equity markets:
A stronger dollar = more expensive exports, which could be bad news for US retailers, who have large European presences. According to research from Bloomberg, Abercrombie & Fitch Company (NYSE:ANF) gets 27% of its net sales from Europe; American Apparel (NYSE:APP) has 18% and TJ MAXX (NYSE:TJX) at 13%.
The EUR has fallen some 10% versus the dollar since peaking in May, and many analysts believe that there is further to fall, while GBPUSD has fallen nearly 7% since July. If the dollar continues to strengthen then we could start to see profit warnings if retailers can’t diversify their earnings in a timely manner. If this trend continues then a stronger dollar could hurt US equities, possibly as soon as the New Year.
Commodities:
The other sector that could struggle is energy. A stronger dollar can weigh on Crude Oil prices, and on Monday we saw oil break down yet again, with WTI falling below $80, and extending gains even further on Tuesday, touching a low of $75.85.
The price of Brent Oil has also fallen dramatically, and this is starting to weigh on energy companies. The energy sector is the weakest sector on the FTSE 100 and the Euro Stoxx index.
In contrast, the DAX index, which has little exposure to energy, and a large exposure to exports, is managing to hold up fairly well today, as a strong dollar could benefit indices like the Dax, as it makes German exports more attractive to the US consumer.
Oil producers could also be hurt by a stronger buck. If oil producers are earning less then this means they are spending less, which could mean a drop in global liquidity levels. If liquidity levels drop then money should get more expensive, which is bad news for risky assets like stocks, EM assets and commodity currencies, like the CAD, AUD, and NZD.
Fundamentals:
At the start of this quarter we mentioned that the rhetoric at the Federal Reserve had shifted slightly from talking about the unemployment picture to talking about weakening inflation picture. The rising dollar could become a problem for the Fed, as a rule of thumb for every 10% increase in the dollar, inflation falls by 0.5%. Since CPI in the US is already at 1.7%, a stronger dollar could become a headache for the Fed going forward.
On the other hand, a stronger dollar could be a blessing for the ECB, as it could boost exports and help to reflate the economy, as imports get more expensive. But for us in the markets, the biggest impact could be on the data front. Non-Farm Payrolls have been the most important data point from the US each month, however in this environment the CPI figures, the next batch is released on 20th November, could replace NFP as the most important event for markets this year.
FX:
The stronger dollar has caused a wave of change in the FX space. As you can see in the chart below, as the dollar has rallied, volatility has risen. The Y access shows the spot return vs. the USD for the last 3 months, while the X access shows volatility. The most volatile currency with the largest decline vs. the USD was the RUB, while the BRL, which did not fall as far as the RUB, had the highest overall volatility out of all of the expanded majors.
In the middle of the chart you will notice a cluster of currencies, mostly from the G10, which have seen an increase in volatility that has corresponded with weakness against the dollar. The most severe has been the JPY and the SEK, after both central banks adjusted monetary policy recently. However, the AUD, EUR, NZD and CHF have all been impacted.
The only currency that has performed on par with the USD has been the CNY, which figures as it is held in a de-facto peg against the greenback.
So what can we extrapolate from this chart?
1) As long as the dollar continues to rally, then volatility could stay elevated in the G10 space. That is good news for traders, as volatility means opportunity, but it could also be a bumpy ride.
2) Volatility does not stay elevated indefinitely, so as volatility falls watch out for some pull-backs, particularly in the JPY, BRL, SEK, JPY and NZD, as they are all looking fairly stretched to the downside vs. the USD.
To conclude:
- We could be at the start of a multi-year uptrend for the dollar after a major technical development on Monday.
- This could have a wide-ranging impact on global financial markets, in particular on some US export companies, especially retailers and energy companies, as well as on commodity prices.
- The strong dollar also comes with problems, if the Fed starts sounding concerned about the strong dollar’s impact on inflation then we could see the dollar rally stall in the short term.
- FX: some G10 currencies look stretched to the downside vs. the USD and could be due a pull-back; however, in the long-term a stronger dollar is triggering volatility in FX markets, so it could be one hell of a ride if the dollar rally continues to gather pace.
Source: FOREX.com and Bloomberg
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