Strong Dollar Pressures Assets as Market Rotation Looms

The US dollar has surged nearly 4% since early September, hitting its highest level in over a year. This rally is unusual because the odds of a Federal Reserve rate hike in October plummeted from above 60% to roughly 25%, following weak employment data and lower-than-expected price figures. Typically, softer policy expectations weaken a currency, but the dollar has defied this trend.

A strong dollar has historically been a headwind for various asset classes. Over the past decade, most major categories have moved inversely to the dollar's movements. The S&P 500, for instance, has averaged a slight loss in months when the dollar rose and gained 2.74% in months it fell. This sensitivity is even more pronounced in foreign equities, as dollar-based investors absorb currency gains or losses.

Long bonds, represented by the iShares 20+ Year Treasury Bond ETF (TLT), have shown a 1.18% monthly loss when the dollar strengthened. While a strong dollar often reflects safe-haven demand and supports Treasuries, this relationship didn't hold in recent years due to significant market moves in 2022.

Current market conditions suggest a potential rotation. Technology is overbought, while sectors like energy are at fair value, and others are oversold. Interest-rate-sensitive sectors appear most oversold, whereas economically sensitive sectors are less so. The divergence between technology and real estate investment trusts (REITs) over the last six weeks highlights this trend. Extremely high negative correlations between sectors and technology may not last but could drive relative sector returns in the near future.