How Will The Stock Market React If The US Dollar Rises?

As the G20 concludes and the US equity markets decline, the US dollar is playing pivotal role in both the foreign currency markets and geo-political posturing. Last fall, during the height of the economic crisis the US dollar index broke a 6 year downtrend which began in 2002. As the dollar peaked in March 2009, the US equity markets began to find firmer footing and the year long relationship between the dollar and equities blossomed.

US Dollar Index (Cash) - Monthly Chart

Over the last 6 months the Us dollar index has declined in what may turn out to be a correction. Furthermore, over the last 6 months both the implied volatility and historic volatility have been cut in half from above 20% to below 10%.

Implied Volatility and Historic Volatility on US Dollar Index Futures Options

We also note that since the beginning of September the implied volatility index has climbed substantially above the historic volatility. The implication is option traders have been expecting a big move in the dollar index.

While implied volatility tells us what the market is expecting it does not tell us the direction of the expected volatility. In the US dollar index, the implied volatility on both the puts and the calls have been rising in tandem, which means they offer little information for directional analysis.

Combining the technical and volatility analysis we deduce the likelihood of a dollar reversal has increased significantly. Adding the weakness in the US equity markets fortifies our conclusion. Just as the weak dollar fueled the rise in the equity markets it is possible that the strong dollar fuels a decline.

The two markets can form a vicious circle that mirrors the action we have seen over the last 6 months. The stronger the dollar gets the weaker the equity markets become, this weakness in turn causes a flight to safety and the dollar becomes stronger.

But what is the fundamental fuel for a rising dollar? Glad you asked. To complete this analysis we must distinguish between a benevolent dollar rise and a malevolent rise.

Benevolent Fundamental Reason for Dollar Strength

Under the benevolent scenario, the dollar strengthens because the US economy is improving and the Fed begins to drain liquidity. The markets anticipate the “tightening” and begin to bet a rate increase is next, thus making the dollar a higher yielding currency. We have seen this type of reaction to the Fed’s most recent statements on reverse repos.

For the last few days, stories have “leaked” that the Fed will conduct reverse repos to drain liquidity from the system. First it was leaked that these action would be conducted with primary dealers. Then, money market funds were targeted as the object of the Fed’s affection. Conveniently, the “leaked” stories also mentioned the Fed may want to conduct a few tests but were afraid of spooking the markets. Now that the news has been released we expect to see a few “tests” conducted which may be the first catalyst for significant dollar strength.

In this case the equity markets will fall initially as investors digest the new paradigm. Once investors realize the rising dollar is due to improved economic conditions they will once again purchase equities and we can begin a new phase of the bull run.

Malevolent Fundamental Reason for Dollar Strength

The other side of the coin is the unhappy reasons for a strong dollar. We see the catalyst for this to be a weak economic event. It could come from commercial mortgages, it could come from increased taxes, and it could come from protectionism. Sadly, we can find more malevolent reasons the dollar could strengthen than benevolent.

Regardless of the reason, under the malevolent scenario the rising dollar reduces the profit margins of US multinationals which get a majority of their revenue from overseas. The reduced margins results in further layoffs and the economy suffers a double dip recession. In this scenario, the US equity markets would continue to decline and likely trade well below the March 2009 lows.

The US equity markets and the US dollar are still attached at the hip. The real question that investors must ask themselves is whether or not a stronger dollar is a signal of fear or economic improvement.

Disclosure: Long UUP

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