Posted by Adam Turnquist, CMT, VP Chief Technical Strategist
Friday, December 9, 2022
Selling pressure over the last several weeks has left the U.S. Dollar Index near an inflection point. Falling interest rates have primarily been responsible for the recent decline. Prior to last month’s 5% drop (the largest since 2010), the dollar was trending sharply higher and outperforming most other assets with a +15% year-to-date (YTD) return at the end of October. The dollar’s outsized gain was attributable to outsized tightening as the Federal Reserve (Fed) raised the federal funds rate by 4% this year, essentially ‘out-hawking’ most other foreign central banks. However, recent signs of cooling inflation pressure have sparked speculation for an eventual end to the Fed’s rate hike cycle next year, pouring some cold water on the dollar’s bullish narrative.
Technical Setup: As shown in the LPL Financial Chart of the Day, the U.S. Dollar Index has dropped back near key support at the 105 area, which lines up close to the rising 200-day moving average (dma), prior highs and lows, and the 38.2% Fibonacci retracement level of this year’s advance, another level that technical analysts watch for potential support. A further breakdown in the dollar would leave 103 (March 2020 highs) and 102 (50% retracement level) as the next levels of downside support. As shown in panel 2, the Relative Strength Index, a technical indicator used to measure the strength of a trend, is near oversold levels. A rebound off support would leave 108.50 (July highs) and 109.25 (declining 50-dma) as the next key levels of overhead resistance.
Given the negative correlation between the S&P 500 and U.S. Dollar Index, a breakdown or rebound in the dollar would likely have a meaningful impact on equity markets. Next week could also be a major catalyst for dollar volatility. The Fed is expected to raise rates by 50 basis points (bps) on Wednesday, marking a slowdown from the last three 75 bps increases.
The European Central Bank (ECB) is also expected to slow the pace of tightening from 75 bps to 50 bps on Thursday. Similar to the U.S., there have been recent signs of abating inflation pressure within the Eurozone. The euro also holds around a 58% weight within the U.S. Dollar Index, meaning changes in the euro’s relative value can have a big impact on the dollar.
Finally, the U.S. Consumer Price Index data will be released on Tuesday. Headline inflation is expected to decelerate in November from 7.7% to 7.3% based on year-over-year comparisons. Core CPI is also forecasted to recede from 6.3% to 6.1%. For context on price action surrounding recent CPI reports, the dollar has moved -2.2%, -0.8%, +1.4%, and -1.1% during the last four CPI release days. The lesson? Expect volatility next week.
What could a breakdown or rebound in the dollar mean for equity markets? The matrix below highlights the correlation between the U.S. Dollar Index, the S&P 500, and its sector ETFs. The correlation data was calculated from weekly returns over the last year.
Key takeaways: The S&P 500 and all of its sectors have been exhibiting a negative correlation to the dollar, not surprising given that the dollar is up and equity markets are down, but it’s not unusual for the dollar to show some strength during an equity downturn. In the event of a further breakdown in the dollar, financials and materials could capture tailwinds based on their relatively large negative correlations. If the dollar does rebound, consumer staples, energy, and utilities could see a pickup in relative strength as they have the least negative correlation to the dollar.
Taking it one step further, we also found the top and bottom five S&P 500 industry groups based on their correlation to the dollar. Health Care Technology was the only industry group with a positive correlation to the dollar based on weekly returns over the last year.
We ran a similar analysis for commodity markets and unsurprisingly found several metals with the largest negative correlation. Title Transfer Facility (TTF) Natural Gas, essentially Dutch natural gas futures, was the most positively correlated at +0.31, while several grain commodities also made the list.
In summary, the dollar has dropped to an inflection point. Further selling pressure in the greenback below key support at 105 should benefit the broader equity market. Financials and materials could see a lift in relative strength, as they are the most negatively correlated to the dollar. The metals complex would likely also benefit from a further breakdown in the dollar.
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