Originally posted at Briefing.com.
It's dollar days for the market, yet nothing is really on sale. The only thing that looks remotely cheap is the cost to insure one's portfolio against downside risk. The CBOE Volatility Index is the tell there. It slumped as low as 12.50 in the past week after peaking at 30.90 on February 11.
A market that was awash in fear not that long ago is suddenly basking again in complacency. That's the view from the cheap seats anyway when looking at the Volatility Index.
Read Chart of the Day: With Stocks Near All-Time Highs, Financial Stress Turns Negative
The rally since mid-February has left many sidelined investors green with envy. Actually, it would be more poetic to say that they have been left greenback with envy since the weakening dollar has played a leading role in the rally effort.
We'll examine the drivers behind that weakening and offer some musings about how the weaker dollar might not be the best thing if it leads to dollar strength ahead of its fundamentally appointed time.
Reversal of Fortune
A lot of traders like to keep their eye on the US Dollar Index as a proxy for determining whether the dollar is strengthening or weakening. It's really not the best determinant, though, since it only includes six component currencies—the euro, the Japanese yen, British pound, Canadian dollar, Swedish krona, and Swiss franc.
Furthermore, the euro has a 58% weight in the index, providing it with some outsized influence in driving the index. The yen has the next biggest weight at just 14%.
Read also Is the Dollar’s Major Bull Run Over?
The US Dollar Index is not a terrible indicator. There is certainly plenty of business that gets transacted using the euro and the yen, but because the global trade net is so much wider, the better determinant is the Federal Reserve's Broad Effective Exchange Rate Index.
The latter includes the Chinese yuan, the Mexican peso, and the Korean won in addition to the currencies mentioned above, as well as many other currencies for economies whose bilateral share of US imports or exports exceeds 0.5%.
With this in mind, let's take a look at some charts showing both a long-term and short-term timeframe of the Nominal Broad Effective Exchange Rate Index.
What is evident in the chart on the left is that the dollar made a significant move higher beginning in July 2014, which was shortly after oil prices peaked around 0 per barrel. What is evident in the chart on the right is that the dollar has been weakening noticeably since January 20 or shortly before the Bank of Japan surprised capital markets with the adoption of a negative interest rate policy (NIRP).
Now, let's look at an overlay of the Nominal Broad Effective Exchange Rate Index with oil prices and the S&P 500 since the start of the year.
Briefly, the Broad Effective Exchange Rate Index is down 2.7% for the year, oil prices are up 16.3%, and the S&P 500 is up 2.3% (through April 21). Oil prices and the S&P 500 of course began their huge rebound efforts on February 11. At the time, the Broad Effective Exchange Rate Index was up 0.8% for the year, yet it has been fading ever since.
The drivers of the weakening dollar have included the following:
- The adoption of NIRP by both the Bank of Japan and the European Central Bank (ECB), which convinced market participants that the Federal Reserve would not be able to embrace a strong divergence in its policy versus other major central banks. That sapped the divergence trade, which was a major driver of the dollar's strength entering the year.
- The Federal Reserve validating the market's thinking by cutting its expectation for four rate hikes this year to two
- Weakening economic data in the first quarter that continued to suppress the market's rate hike expectations
- Economic data out of China that pointed toward signs of stabilization in the economy there and reassurances from Chinese officials that they did not intend to allow a significant devaluation of the yuan
- G20 members reiterating in February their pledge not to engage in competitive currency devaluations
- Less demand for US dollars as capital flight from abroad slowed with the rebound in local stock markets
Hang Ten
So, what happened exactly when the dollar weakened and kept weakening?
- Oil and other commodities rebounded sharply
- Stock markets in emerging economies rallied (and in developed economies too)
- High-yield spreads collapsed
- Inflation expectations rose
- US stock prices shot higher, with large-cap multinational companies helping to set the pace; and
- Treasuries retreated as safety trades were taken off and risk trades were put on
There was essentially a wave effect that flowed from the weakening dollar and, boy, did risk assets hang ten. They were feeling the rush of the view that a weaker dollar is going to be the ticket to better economic and earnings growth in the second half of the year.
That has been the mindset of this market, which is cognizant that a stronger dollar has been a major headwind for US multinationals' earnings prospects, a major drag on US exports, a major weight on dollar-denominated currency prices, a major source for disinflation, and a major draw for foreign capital that exacerbated volatility with the flight from foreign markets.
The table below is a truncated performance table intended to show how risk aversion has been supplanted by risk conversion over the last three months. The returns are eye-opening and show how the dollar Visine has helped get a lot of the red out of the performance tables.
Source: FactSet
There has clearly been a repositioning trade that has favored cyclical sectors and economically-sensitive areas. In conjunction, the collapse in credit spreads and a Treasury yield curve that has started to steepen again also reflect some renewed enthusiasm for the economic outlook, which will presumably include a pickup in inflation.
What It All Means
As the market keeps riding the dollar wave, it needs to be on the lookout for a rogue wave. Ironically, that rogue wave may just be the dollar itself.
If things pick up as the market now expects, that could invite more tightening from the Fed sooner than the market expects.
The great disconnect at the moment is that the stock market is riding high on the prevailing argument of an economic and earnings recovery being in the works, and yet the fed funds futures market hasn't changed nearly as much as the prevailing argument. At the moment, it places only a 51% probability on the next rate hike occurring in November.
In our February 19 column, A Potentially Big Risk in Glide Path Schism, we discussed how it could be a big source of disruption for the equity market if it needs to adjust to the reality of the Fed raising the policy rate more, and faster, than it now expects.
Right now, the equity market is acting as if it will have its porridge and eat it, too, with improving economic growth, strong earnings growth, and a tempered rise in inflation. It is a Goldilocks outlook alright, which only makes sense since that is the only fairy tale that has ever registered with this market since the Fed adopted its extraordinary monetary policy in 2008.
However, Goldilocks may not get out of the bears' house so easily this time if inflation rises faster than expected, the Fed hikes more than expected, and the dollar takes off again on the policy divergence trade.
