You need to start watching the US dollar

A sustained rally could have important implications for American and multinational companies, potentially resounding across the stock market.

By MSN Money Partner Aug 21, 2014 2:02PM
Image: Money © MedioImages/JupiterimagesBy William Watts, MarketWatch

After a long, sleepy stretch, the dollar is breaking out to the upside, and it’s not just currency traders who need to pay attention.


The ICE dollar index, which tracks the U.S. currency against a basket of major rivals, quietly pulled off a breakthrough this week, punching to its highest level since September and trading recently at 82.044. 


The currency extended big daily gains Wednesday versus the euro and Japanese yen after the minutes from the Federal Reserve's latest meeting struck a surprisingly hawkish note.


"There's a late-summer feel to the weather and a spring in my step as the dollar has finally slipped its moorings and edged up and out of the doldrums," said Société Générale global macro strategist Kit Juckes, in a note.


A sustained dollar rally could have important implications for U.S. and multinational companies, potentially resounding across the stock market and other asset classes.


Short-term technical indicators point to more upside for the dollar index, writes Greg Harmon, founder of Dragonfly Capital, in a Wednesday blog post. And if the index's move over the past year turns out to form "rounded bottom" or a "cup and handle" -- both are technical patterns -- the index could have room to test the 83.50 level, he says.


That would be a "big move for this stable asset and one that would garner even more attention from longer-term investors," Harmon wrote. "For now, the short-term trader can be excited, but it is still boring for the investor. But it is time to start paying more attention."


What's behind the dollar rally? Diverging monetary policy is one oft-cited reason. The U.S. Federal Reserve is winding down its quantitative-easing program and is seen on track to begin hiking interest rates next year. That stands in contrast to the Bank of Japan, which remains in quantitative-easing mode, and the European Central Bank, which is widely expected to be forced reluctantly down the road of outright QE to avoid the Japanification of the euro-zone economy.


As a result, even though U.S. bond yields remain extremely low, they're more attractive to investors than yields in Japan and Germany.

"Over the really long term, the dollar tracks real U.S. rates [rates minus inflation] as closely as it tracks anything," Juckes said.


Strategists warn this could be another false dawn for dollar bulls. But if the rally does have legs, it could have implications for stocks as well.


Over a 20-year period, the dollar index's correlation coefficient with the Standard & Poor's 500 Index ($INX) was 0.38, according to Investopedia. The positive coefficient means that when the value of the dollar rises, the stock index tends to rise, too. In this case, around 38 percent of the S&P's move are associated with the movement of the dollar.


But it gets more complicated. Matthew Weller, senior technical analyst at Forex.com, notes that the correlation "oscillates between strongly positive and strongly negative depending on the trading environment we're in."


This chart via StockCharts.com shows the 26-week correlation between the S&P 500 and the dollar index over the past three years -- a pattern Weller notes is "relatively inconsistent."

Credit: Stockharts.com

"When we're in a risk-on/risk-off environment, like we were in midst of the Great Financial Crisis, the correlation tends to be negative (ie. stocks fall when the dollar rises and visa-versa)," Weller said in an email. "Lately, the correlation has been strongly positive, reflecting traders' demand for U.S. assets amidst the recent strong economic performance."


Whether the positive correlation continues should the dollar extend its rally is an important question for investors. If a stronger dollar is seen crimping earnings, it could spell trouble for equities. But if the rally is built on expectations the U.S. economy will continue to outpace its peers, it wouldn’t necessarily stand in the way.


The relative strength of the U.S. economy and the stock market since the worst of the financial crisis has helped to boost the dollar, said Sameer Samana, senior international strategist at Wells Fargo Advisors, in a note.


"We believe the expectation for faster growth in the U.S. should lead to continued outperformance by U.S. equities," Samana said. At the same time, a weaker euro and yen should boost earnings prospects for companies based in the eurozone and Japan, he said, and recommends a tactical overweight position on developed-market equities.


More from MarketWatch

18Comments
Aug 21, 2014 3:36PM
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We don't watch the dollar we're watching our pennies.
Aug 21, 2014 4:09PM
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It's a forced fiat currency, period. They last about 75 years before being replaced. It is sad testament to the economic conditions in the rest of the world when the toilet paper US dollar is seen a good 'investment', when the reality is the dollar isn't worth a plug nickel after almost seven years of reckless, boundless overprinting by "Benny Bucks" Bernanke and  the Fed . 
Aug 21, 2014 3:55PM
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Yeah, you better watch the dollar, when the IMF does a currency reset, the dollar will plunge and a loaf of bread will be 7 bucks.
Aug 21, 2014 4:05PM
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dollar?? who has any left in their pockets to watch?
Aug 21, 2014 5:52PM
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"You need to start watching the US dollar..."


...when it eventually collapses due to the Fed's printing at warp factor 9.


Is anyone really believing that the dollar is still a strong currency??? It has no backing except for the government's "Really - our money is good, we swear!" statement. I'm not buying into this article

Aug 21, 2014 6:09PM
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The Fed. is at record debt of $4trillion and going in debt more everyday. So bankruptcy is coming for the USA some day.
Aug 21, 2014 6:10PM
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"We believe the expectation for faster growth in the U.S. should lead to continued outperformance by U.S. equities," Samana said"

Like he would say anything else? Regardless of the actual state of the Economy, these frauds state the same thing.
Aug 21, 2014 6:09PM
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I am trying to design a molecular sieve to evaporate the QE part of the dollar. This will leave the real value of the dollar intact.  No luck to date. I will keep you posted.
Aug 22, 2014 10:13AM
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You all can say mass about the frogskin, but having even a small roll of one-hundred dollar bills in your pocket truly brightens your day and that of those around you..

Traveling out of the country is a bliss when you carry with you a convenient amount of cash in dollars as you realize that all merchants are greatly happy to see you at their shop.


Aug 22, 2014 10:08AM
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I suggest first, we dig up Pres. Wilson and publicly behead him!  Then,  an across the board 12 % income tax, no fancy shifting money around for so called non- profit organization donations , a straight 12% rich & poor.  Higher cost for raw material export and import! Its insane U.S. providing the bulk of cost and peeps for the war in Iraq and their oil ends up being "owned" by foreign companies! Shame on you public! Its their oil. It should be drilled by them, refined by them and sold by them for their countries benefit. I'd say more but, I'm being called by the dots and lines.   ...///...

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