This is what a fall in the US dollar means for the stock market

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The US dollar looks unstable. Barring some sort of currency collapse, a weaker dollar should be positive for equities, although foreign equities are likely to benefit the most, analysts said.

The ICE US Dollar (DXY) index, a measure of the currency against a basket of six major rivals, fell 1.6% last week, hitting a 22-month low on Friday below 94.40, according to FactSet. .

That comes after hitting an intraday high of more than three years on March 22, just below 103, a day before the S&P 500 (SPX) stock index hit its lowest level during the worst coronavirus pandemic. As the dollar faded, stocks rebounded smartly, with the S&P 500 now around 5% below its all-time high set on February 21 after a 34% drop earlier this year.

Knowing exactly what to do with the dollar can be confusing for investors. After all, a weaker dollar is generally considered positive for the US economy, and for large multinationals that record a large share of income abroad, but bear most of their costs at home. However, stocks have performed well during recent dollar bull markets, reflecting the strength of the US economy relative to the rest of the world.

And a weaker dollar is not necessarily good for stocks if it reflects big problems on the home front.

Last week, both the dollar and stocks lost ground, and the currency was unable to obtain much of a safe haven from an outbreak of tensions between the United States and China. The S&P 500 (SPX) fell 0.3%, while the Dow Jones Industrial Average (DJIA) decreased 0.8%.

But in the long term, the dollar and stocks have exhibited a slight negative correlation, meaning that a weaker dollar has been marginally good for stocks. Since 1973, the correlation between the trade-weighted broad dollar index and the S&P 500 monthly is -0.2, said Jeffrey Schulze, investment strategist at ClearBridge Investments.

However, that inverse relationship has been much stronger more recently. Since 2000, roughly coinciding with China’s joining the World Trade Organization, the correlation has been -0.35, Schulze said.

In the meantime, the important thing to remember is that the performance of any currency reflects what market participants think of the prospects for one particular economy versus another.

“A weaker dollar does not necessarily reflect a weak US economy, but rather reflects a stronger global economy on a relative basis,” Schulze told MarketWatch in an interview. While that doesn’t mean fatality for US stocks, they are likely to underperform their global counterparts in the next six months, he said.

US stocks may be particularly vulnerable to poor performance against Europe, where the COVID-19 pandemic appears to remain largely under control. European politicians, too, were finally able to meet last week and deliver a major milestone in the form of massive spending and a rescue plan, while the European Central Bank has been aggressive in delivering monetary stimulus. The euro (EURUSD), which stands at a weight of approximately 19% against the dollar in the weighted index, has exploded, increasing 1.8% in the last week to trade in a maximum of 10 months above $ 1.16.

In fact, the strengthening of the euro, which rose 3.6% in July, continued to rebound even as US and global stocks ended the week on a lower note. This may be a sign that investors are beginning to see the euro through a different lens, possibly seeing it as the next safe-haven currency, said Pairsh Upadhyaya, director of currency strategy at Amundi Pioneer, in an interview.

The case of the US underperformance is also supported by a look at the negative correlation between the dollar and non-US stocks, which is stronger than the relationship between the currency and US stocks, said Gaurav Saroliya, director of macro strategy. from Oxford Economics, in a note on Thursday (see table below).

© Oxford Economics

Some economists have warned that the dollar could unravel quickly and disturbingly, rapidly eroding its status as a global reserve currency and sending shock waves through financial markets as the United States struggles to control the COVID-19 pandemic.

Read: Falling US Dollar Could Happen at ‘Warp Speed’ in Coronavirus Era, Warns Leading Economist Stephen Roach

Saroliya argued that the dollar is unlikely to suffer such a bleak scenario, noting that the currency has experienced previous bear markets in the 1970s, late 1980s, and mid-2000s, while serving as the currency of preeminent reserve of the world.

“Far from being destabilizing to world markets and the global economy, those episodes were quite positive for growth,” he said, noting that the reverse link between the dollar and global economic growth has existed for most of the era of the United States. Free exchange rates since the 1970s, while periods of rapid dollar appreciation have been more of a threat to global financial stability than major falls in the dollar.

The behavior of the dollar during the height of the global market turmoil generated by the pandemic earlier this year underscored the role of the currency as a refuge.

Nicholas Colas, co-founder of DataTrek Reseach, noted that the trade-weighted dollar index peaked the same day the S&P 500 bottomed out in both the 2008-09 financial crisis and the coronavirus panic in early this year. On March 9, 2009, the index closed at 106.01, a level it did not reach again until 2015, he said, while the index reached a record high of 126.47 on March 23 of this year. Since then it has fallen more than 5%.

The bottom line is that “a weaker dollar is confirmation that global investors feel the worst of the COVID crisis has passed and validates the recovery in stocks against the March lows,” said Colas. In other words, don’t worry that a weaker dollar is a warning sign about a sudden decline in US stocks. History testifies to the contrary.

Currency traders and investors in the US stock market face a busy week ahead when it comes to data and events. The Federal Reserve will announce the outcome of its next policy meeting on Wednesday.

While the Fed is not expected to take any major action, the minutes of the last meeting suggest that the committee is moving toward a “results-based approach to accommodation,” wrote market economists at RBC Capital.

They want the committee to detail “how the economy would have to evolve to make it comfortable adjusting politics.”

“Maybe [Fed Chairman Jerome] Powell will provide some additional color on what this would look like at his press conference, ”they wrote.

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