- The dollar is surging once again and could have much further to climb.
- The dollar is rising, thanks to rising interest rates.
- This could kill the remaining parts of the risk-on trade.
- Looking for a helping hand in the market? Members of Reading The Markets get exclusive ideas and guidance to navigate any climate. Learn More »
Stocks have turned sharply higher since Friday afternoon, with the S&P 500 seeing a meaningful rally. Still, the S&P 500 appears to continue in a direction that remains lower as the culprit for what has pushed stocks down is not a narrative but a fundamental change in the market.
What may make matters worse now is that rising rates have given the dollar a boost, and that could add another layer of stress for risk assets. Additionally, there are signs the dollar is likely to strengthen further, creating big problems for many commodities and commodity-linked sectors of the equity market.
Higher Rates Are Pushing The Dollar Up
If the material and industrial parts of the market go, it seems possible that S&P 500 will have major problems, as there will be no sectors other than financials left to carry it higher. The S&P 500 has held up better more recently due to the strength of the commodity-linked parts of the market.
However, with rates on the 10-year rising so sharply, it has made US bonds more attractive to those bonds overseas. It has widened the spread between US bonds and German and Japanese bonds. The dollar collapsed due to a steep contraction in the yield spread during the sell-off in March of 2020. Those wider spreads and rates also help bring capital inflows back to the US for investment.
Those spreads are again widening and sending foreign investors back into US bonds, resulting in foreign investors buying US dollars to fund US debt purchases. The difference between the US 10-Year and the German 10-Year has nearly doubled from around 1% over the summer to around as much as 1.9%. The same is true of US 10-year rates and Japanese 10-Year rates. In this case, the spread has widened from around 60 bps to 1.55%.
The result has been a Japanese yen that's now breaking down vs. the dollar and could have considerably further to weaken. The Yen has recently risen above a key downtrend at the 105 level and has seen an explosion of bullish momentum behind it. While it might be a bit ahead of itself short term, a move above 109.5 in the yen could make the currency significantly weaker, heading all the way back to 114.50. Remember, a rising yen is an indication the currency is weakening vs. the dollar.
The same is true of the euro vs. the dollar, as the currency is now weakening and has recently fallen below the 1.2 level vs. the dollar. It could result in the euro dropping to as much as 1.14 to 1.16 vs. the dollar.
Both the ECB and the BOJ would applaud a weaker euro and yen. It would help ease some of the deflationary pressures a strong currency has on the economy and help boost their growth rates.
This would likely result in the dollar index rising further, too, with its next resistance level not coming until 93.70. Additionally, the dollar index's momentum has turned distinctly bullish, as noted by the RSI, which now has an uptrend that has formed off the August lows. It could result in the dollar climbing all the way to 96.
Commodities In The Way?
This is likely to harm commodities such as copper and other metals. The metal has seen a huge jump in its price as inventories are low. However, it has been a beneficiary of the dropping dollar, as commodities have an inverse relationship to the dollar, with the potential to fall back to $3.70.
Oil would also fall into this camp based on the stronger dollar, on the same concept. Oil prices have surged to almost $70 in recent weeks. However, it could easily decline back to $60.
Energy and Industrials To Falter
A decline in oil and many metals would stop the big run in the equity market's energy and material parts. These sectors have been very hot this year and have helped to some degree dampen the blow to the S&P 500 that the higher yields have put on the technology part of the market. But if these sectors go, it will pressure the banks and the industrials to keep the momentum higher in the S&P 500.
But the industrial stock could falter, too, because a strong dollar will likely lead to tough revenue and earnings comps in future quarters. A strong dollar will act as a headwind to many companies that export their products or sell products overseas. It will reduce earnings and revenue for these companies, causing analysts to cut estimates and lead to lower stock prices.
Tailwinds To Headwinds
The tailwinds that have helped to lift the S&P 500 to record levels are now turning to headwinds. The low interest rate environment helped to drive valuations to very high and stretched levels. Now higher rates are compressing those multiples bring those stock prices down.
Also, those higher rates are causing the dollar to break out and likely head even higher. If that happens, there will be nothing left to push equities price up from here.
Reading The Markets is designed to provide members with a better understanding of the stock market and to provide stock ideas. Just like the free articles you have grown to love reading.
Or if you want to learn about how the markets function, I can teach you that too.
This article was written by
Mott Capital, aka Michael Kramer, is a former buy-side trader, analyst, and portfolio manager with 30 years of experience tracking market fundamentals. He focuses on long-only macro themes and studies trends and unusual options activities to identify long-term thematic growth opportunities.He leads the investing group Learn more .
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Mott Capital Management, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Upon request, the advisor will provide a list of all recommendations made during the past twelve months. Past performance is not indicative of future results.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.