Home / Daily Market Recap / Thu, Dec 24 – What Does A Strong Dollar Mean For Other Asset Classes?

Thu, Dec 24 – What Does A Strong Dollar Mean For Other Asset Classes?

No live market update today as markets are now in complete holiday mood, but we want to use the opportunity to provide an outlook for 2016. With the recent developments and the FED announcements of additional rate hikes going forward, we want to take a look at what a stronger US-Dollar means for other financial markets.

 

Equities

The US-Dollar and equities have an historically inverse relationship. When the Dollar moves up, equities typically go down.

A stronger Dollar puts pressure on corporate earnings because large companies earn a substantial amount of their income outside of the US. Thus, a stronger Dollar means that the value of the revenue declines when the Dollar is strong.

Furthermore, when the Dollar strengthens, imports become less expensive because the value of the Dollar rises compared to other currencies. At the same time, exports become more expensive for people outside the US when the Dollar rises. Less domestically produced products can put pressure on the economy and the labor force.

 

US-Dollar Index and S&P 500 - Correlation at the bottom
US-Dollar Index and S&P 500 – Correlation at the bottom

 

However, there are times when the relationship changes and the Dollar and equities move into the same direction. As the screenshot below shows, late 2015 has been such a time. A possible explanation is that the recent rally in the S&P 500 we have seen from 2013 on created a higher demand for the US-Dollar as more foreign investors had to purchase US-Dollars before buying US stocks.

 

Oil and commodities

The relationship between the US-Dollar and Oil is a negative one. As the US-Dollar rises, Oil drops. Since most commodities are priced in US-Dollars, a strong Dollar puts, pressure on commodities.

When the US-Dollar appreciates and is “worth more”, it takes less Dollar to buy the commodities and Oil which, of course, lowers the price of Oil. Also, a higher Dollar makes Oil, relatively speaking, more expensive for foreign investors and companies which weighs on demand even further and also reduces the price of the commodity.

 

US-Dollar Index and Crude Oil - - Correlation at the bottom
US-Dollar Index and Crude Oil – Correlation at the bottom

 

Oil, Dollar and equities

Companies can benefit from falling oil prices because it lowers the cost for raw materials and increases margins. And retailers can benefit from falling Oil when it drives down gasoline prices and leaves the consumer with more money to spend.  On the other hand, energy companies are hurt by falling Oil prices because it negatively affects their revenue.

We have said previously that equities and the Dollar move in different directions and that the US Dollar and Oil also move in different direction. Thus, the relationship between Oil and equities is mainly a positive one as the screenshot below shows.

Crude Oil and the S&P 500 - Correlation at the bottom
Crude Oil and the S&P 500 – Correlation at the bottom

 

Emerging markets

This topic is a very important one, but it not often makes the headlines unless something major happens. Many developing countries have unstable currencies and, therefore, decide to borrow money in US-Dollars to eliminate some of the currency risks. However, when the developing country weakens and the government is not able to repay its debt in US-Dollars, countries run the risk of defaulting on its debt. A famous example of that is Argentina in 2001.

Another famous example is Petrobas – a Brazilian oil company. Petrobas borrowed US-Dollars when investors were looking for higher returns outside the US. But as the Brazilian Real depreciated, it became much more expensive to repay the US-Dollar debt and Petrobas was suddenly under a lot of pressure.

US-Dollar and Brazilian Real
US-Dollar and Brazilian Real – A strong Dollar and a weak Real at the same time

 

Petrobas - source: Yahoo Finance
Petrobas. Plunging from $20 a share to below $5 – source: Yahoo Finance

 

A strong Dollar makes Dollar denominated debt more expensive and countries that have to repay debt with US-Dollars have to use more of their own currency to service the debt. Which, of course, often weakens the own currency if easing mechanism are used.

 

Other currencies

The term “currency war” has come up frequently during the last few years, but what does it actually mean?

As we have said earlier, a strong US-Dollar makes imports from foreign countries relatively speaking cheaper for the US. Thus, the imports increase and exports decrease because, for the rest of the world, it is more expensive to buy US good.

Countries that heavily depend on exports, therefore, need a weaker currency to boost exports and help their economy. In this context, the term “currency war” refers to a planned devaluation of the own currency to stimulate exports and the own economy.

Previously, the US tried to weaken its currency with QE (quantitative easing) swamping the markets with US-Dollars to drive down its value. The recent US-Dollar strength puts pressure on the US economy, especially since the Euro and other currencies have depreciated significantly. But now with addition FED rate hikes, it will allow the US-Dollar to rise even further. It will be interesting to see how the FED will counter the effects of additional rate hikes and a strengthening Dollar to make the US competitive.

 

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2 comments

  1. great information thank you. could you please make an article illustrate which news , economic indicators and other forces have the greatest impact on each of the major currencies in the forex market?

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