Earlier this week, we saw a spike in the U.S. dollar. After months of being stuck in a sideways trading pattern, the U.S. dollar (NYSEARCA:UUP) is starting to aggressively move upward:
Why is the U.S. dollar suddenly rising?
Global investors are starting to allocate to dollars. While the U.S. has its own problems, the dollar is still the strongest currency in the world and is viewed by many as a safe haven.
Last week, Moody's downgraded the U.K. credit rating as the credit ratings agency is worried that growth will remain sluggish in the U.K. for the next few years. Anticipation of the downgrade has already caused the British Pound ($XBP) to drop vs. the U.S. dollar.
In addition, many foreign investors are viewing the upcoming sequestration in the U.S. as a positive since it is a form of debt reduction.
What does a rising dollar mean for the stock market?
Since the 2008 market collapse, the U.S. dollar and U.S. stocks have shared a negative correlation. In other words, stocks have risen whenever the U.S. dollar has dropped.
This negative correlation is mostly related to the way corporate earnings from overseas are booked.
Fifty to sixty percent of global corporate earnings and profits are non-U.S., i.e. "booked" overseas in a currency other than the U.S. dollar. When the U.S. dollar weakens, global corporate profits rise when earnings in euros, yen, etc. are converted back to dollars.
As the majority of Fortune 500 companies derive up to two-thirds of their profits from overseas, a strong U.S. dollar is not something U.S. investors should cheer for.
U.S. goods are less competitive overseas since a strong dollar means foreigners can buy fewer U.S. goods with their own currency. In turn, a strong dollar also makes foreign imports more competitive here in the U.S.
The rising dollar may already be having an impact on corporate earnings, as earnings are starting to weaken:
Source: Bespoke Investment Group
During the current cycle (since 2000) as the U.S. dollar has fallen, imports and exports have been significantly impacted from just a 10 percent drop in the dollar's value. It is safe to assume the reverse will hold true if we enter an extended period of strengthening in the dollar:
Source: Center for Economic Policy and Research, Bureau of Economic Affairs
Strong Dollar = Good News At The Pump
Historically, the energy sector performs strongly this time of year. While oil (NYSEARCA:USO) has risen lately (resulting in higher gas prices), a stronger dollar will begin to help consumers at the pump. When the dollar weakens, foreign oil companies ask for higher prices in dollars because they need to offset the weaker dollar so that they can make the same money in their own currency.
If the dollar continues to strengthen, this correlation will cause oil prices to drop -- leading to some stabilization of gas prices:
Should the Fed Intervene?
The Fed actually has numerous tools it can use to combat a rising dollar, however they may not want to.
The U.S. is still a consumer-based economy, and rising fuel prices means less money consumers can spend elsewhere. Consumers already need a break, due to the uncertainty of the upcoming sequester's impact and rising payroll taxes.
Consumer spending has been slowing since 2011. A drop in gas prices may help reverse that trend:
For the Fed, this will be a tightrope walk: Let the dollar strengthen enough to help lower gas prices, but not too much to cause foreign products to become more competitive and hurt U.S.-based manufacturing.
ARTAIS Model Update
This week, our model issued a buy signal in the U.S. dollar, as overseas worries are causing global investors to reallocate currency portfolios to the dollar.
ARTAIS is still overweight in the Energy sector as rising oil prices will positively impact earnings of companies within the sector.
The remainder of the model still remains fairly conservative while we watch to see if the U.S. stock market is consolidating or has entered a topping phase.
Disclosure: I am long XLE, UUP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.