Friday, July 14, 2023
- Easing pricing pressures in the U.S. have increased market expectations for a peak in the Federal Reserve’s (Fed) terminal rate as early as this month. The potential end of the Fed’s rate-hiking cycle has weighed on the U.S. Dollar Index (DXY).
- Technically, risk appears to be toward the downside as the dollar recently took out support off the February lows, leaving 99.20 and 97.00 as the next levels of support.
- Historically, a weaker dollar has been good news for both equity markets and commodities. The S&P 500 Technology sector could see continued tailwinds from a weaker dollar, as 58% of revenues within the sector originates from abroad (FactSet).
- International stocks also become more attractive when the dollar weakens, including the MSCI EAFE Index, which has one of the most negative correlations to the greenback among the major indexes. The technical setup for the MSCI EAFE has improved after the index surpassed key resistance this week.
- Commodities, especially the metals complex, are another beneficiary of a weaker dollar. Gold is the most inversely related commodity to the dollar and is showing renewed signs of technical strength following its recent pullback to support near $1,900.
Dollar Decline Continues
Easing pricing pressures in the U.S. continue to create headwinds for the DXY. This week’s June CPI report showed core inflation ticked up only 0.2% in June, marking the smallest monthly increase since August 2021. The annual core inflation rate (excluding food and energy)receded from 5.3% to 4.8%. Decelerating consumer inflation was followed by evidence of receding wholesale prices in June. Headline PPI rose only 0.1% compared to last year, while core PPI was up 2.4% on an annual basis, marking the lowest reading since early 2021.
This week’s cooling inflation data moved the needle for Fed rate hike expectations. While the market has largely priced in a 0.25% rate hike in July, fed funds futures imply only around a 25% probability for another 0.25% rate increase by November, compared to probabilities approaching 50% last week.
The potential end of the Fed’s rate-hiking cycle has weighed on the DXY (along with recent strength in the Japanese yen). Technically, the greenback has pulled back from a downtrend and violated support off the February lows. The breakdown was further confirmed by a sell signal in the Moving Average Convergence/Divergence (MACD) indicator. The next downside support levels for the DXY setup near 99.20 (March 2022 highs/Fibonacci retracement level) and 97.00 (2021 highs).
Implications of a Weaker Dollar
Historically, a weaker dollar has been good news for both equity markets and commodities. According to FactSet, around 40% of S&P 500 sales are international. And when the dollar is weakening, international revenues get converted back into more U.S. dollars, boosting overall profitability for U.S. multinational companies.
Technology, the S&P 500’s largest sector weight at 28%, has the highest percentage of revenue (58%) generated outside of the U.S. So while Artificial Intelligence gets most of the credit for technology’s recent outperformance, the downtrend in the dollar has provided a solid tailwind for the sector since October.
The chart below quantifies the negative relationship between the U.S. Dollar Index and several major equity indices.
International stocks also become more attractive when the dollar weakens. For example, in addition to buying a foreign stock, a U.S. investor is also buying the foreign currency needed to purchase the shares. And if the foreign currency is appreciating against the dollar, the return on the foreign stock gets a boost. In addition, dividends are more attractive due to the currency translation amid a declining dollar backdrop. As shown above, the MSCI EAFE is the most negatively correlated index to the U.S. Dollar Index.
This week’s breakdown in the dollar pushed the MSCI EAFE over resistance from the April and June highs (2,160-2,170). Momentum indicators are confirming the breakout, including a MACD buy signal this week. Relative performance is also beginning to improve. The MSCI EAFE vs. S&P 500 ratio chart has reversed an emerging downtrend and appears poised to retest its 200-day moving average (dma). A breakout above the 200-dma would be a constructive sign for continued MSCI EAFE outperformance.
The Strategic and Tactical Asset Allocation Committee (STAAC) slightly prefers developed international equities over their U.S. counterparts. This view is largely based on an improving technical setup for MSCI EAFE, downside risk to the dollar, relatively cheap valuations, and the potential for an earnings recovery ahead.
What About Commodities
Commodities are another beneficiary of a weaker dollar. With most commodities priced in dollars and trading globally, a weaker dollar means cheaper commodity prices in other countries. As shown below, metals are the most inversely related to the greenback, including gold with a -0.67 correlation to the dollar.
Gold’s negative correlation to the dollar was especially apparent this week as the yellow metal broke out from a bullish falling wedge formation. And outside of a weaker dollar, gold continues to benefit from global central bank buying, including China, which added to their gold reserves for an eighth straight month in June. While momentum is moving in the right direction, gold still has to contend with major overhead resistance from the prior highs near $2,070. Silver could be an attractive alternative as the metal is generating better relative strength than gold. Nonetheless, STAAC has a positive view of the precious metals space.
Cooling inflation data has increased market expectations for a peak in the Fed’s terminal rate coming as early as this month. Rate hikes have been a major catalyst for the dollar, and with a likely pause on the near-term horizon, the dollar has struggled to capture a bid. A weaker dollar should bode well for both U.S. and international equity markets. Commodities are another beneficiary of a weaker dollar, including precious metals such as gold and silver.
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