The Fed may have to pull a Bank of England with money supply in the 'danger zone'

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The strong U.S. dollar (USDOLLAR) is currently problematic for a host of countries, but may prove a tricky closer to home soon, according to Morgan Stanley.

"Former US Treasury Secretary John Connally’s famous quotation, 'The dollar is our currency but it’s your problem,' continues to ring true, and this is one reason why some countries have been working so hard to de-dollarize over the past decade," equity strategist Mike Wilson wrote in a note.

The Bank of England faced historic weakness in pound sterling (FXB) against the greenback last week and as yields skyrocketed over the mini-budget it was forced to step in and buy long-dated debt, QE, and delay QT to stabilize the markets.

"Some may argue that the UK is in a unique situation and so this doesn’t portend other central banks doing the same thing," Wilson said. "However, this is how it starts. In other words, investors can’t be as adamant that the Fed will choose to or be able to follow through on its guidance."

The dollar (USDOLLAR) (UUP) is little changed this morning.

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"The US dollar is very important for the direction of risk markets and this is why we track the growth of M2 so closely," Wilson said. "In fact, the primary reason for our midcycle transition call in March 2021 was our observation that M2 growth had peaked."

"Indeed, this is exactly when the most speculative assets in the marketplace peaked and began to suffer – i.e., crypto currencies (BTC-USD) (ETH-USD) (COIN), SPACs (SPCX), recent IPOs (FPX) (IPO), and profitless growth stocks trading at excessive valuations," he added. "Now, we find M2 growth in what we call the 'danger zone' – the area where financial/economic accidents tend to occur."

"In many ways, that’s exactly what happened in the gilts market last week, forcing the BoE’s hand. Some may argue that the fiscal policy announcement from the new administration was the real culprit. However, the reaction in financial markets was so extreme due to the tightening of liquidity in the global system, in our view."

What this means for stocks

Wilson said two questions arise from the analysis of M2.

"The first question to ask is, when does the US dollar become a US problem?" he said. "Nobody knows, but more price action of the kind we’ve been experiencing will eventually get the Fed to back off."

"The second question to ask is, will slowing or ending QT be enough, or will the Fed need to restart QE? In our opinion, the answer may be the latter if one is looking for stocks to rebound sustainably."

A Fed pivot "is likely at some point given the trajectory of global M2 (in USD)," he said. "However, the timing is uncertain and won’t change the trajectory of earnings estimates, our primary concern for stocks at this point."

"Bottom line, in the absence of a Fed pivot, stocks (SPY) (QQQ) (DIA) (IWM) are likely headed lower. Conversely, a Fed pivot, or the anticipation of one, can still lead to sharp rallies."

Dig deeper into why the dollar index is called a globalization barometer.