US Dollar Surge Poses Challenges for Global Markets

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 an October rate hike have dropped sharply from above 60% to around 25%, following weak economic data. Typically, softer policy expectations would weaken a currency, but the dollar's strength persists.

Over the past decade, the dollar's movements have acted as a reliable headwind across asset classes. When the dollar rises, major categories tend to move inversely, with the S&P 500 averaging a slight loss and gaining 2.74% in months the dollar falls. A stronger dollar can shrink revenues for companies with significant international operations, as roughly 40% of S&P 500 revenue comes from abroad.

Foreign equities show even greater sensitivity to the dollar, impacting dollar-based investors in foreign ETFs like IXIC or EEM. Long bonds, such as TLT, have averaged a 1.18% monthly loss when the dollar strengthens, though this trend was largely influenced by the large 2022 moves when the dollar surged and bond prices collapsed.

The current market landscape suggests a potential rotation. Technology is very overbought, while other sectors, particularly interest-rate-sensitive ones, are moderately to very oversold. The divergence between technology and REIT sectors over the last six weeks highlights this trend. Extreme negative correlations between sectors may not last but could drive relative sector returns if bond yields decline.