US Dollar Surge Creates Challenges for Global Markets
The US dollar has surged nearly 4% since early September, reaching its highest level in over a year. This rally is unusual because the odds of an October rate hike have dropped from above 60% to roughly 25%, following weak economic data and lower-than-expected inflation figures. Typically, softer policy expectations would weaken a currency, but the dollar’s strength persists.
This dollar rally has acted as a headwind for various asset classes. Over the past decade, most major categories have moved inversely to the dollar’s performance. 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. Given that about 40% of S&P 500 revenue comes from abroad, a stronger dollar can shrink translated revenues, even without changes in demand. Foreign equities are even more sensitive to dollar movements, impacting dollar-based investors in foreign ETFs like IXIC or EWZ.
Long bonds, such as TLT, have shown a puzzling trend. They averaged a 1.18% monthly loss when the dollar strengthened, which contradicts the usual safe-haven demand for Treasuries. This anomaly is largely due to the significant moves in 2022 when the dollar surged and bond prices collapsed.
Current market conditions suggest a potential rotation in sectors. Technology is very overbought, while energy is at fair value, and other sectors are moderately to very oversold. The interest-rate-sensitive sectors appear most oversold, whereas economically sensitive sectors are slightly less so. The divergence between technology and REIT sectors over the last six weeks highlights this trend. High negative correlations between sectors and technology indicate that this dispersion may not last, but lower yields could force a market rotation.
Active traders’ returns in the coming months may hinge heavily on the bond market. Given the record-high correlations between bond yields and oil prices, events in Iran and oil price movements will influence yields and, in turn, impact relative sector returns.