The dollar has rebounded sharply in recent weeks as rates have risen, and the US economy has been far more resilient than many analysts and investors have feared. This rebound in the dollar could lead to a much more substantial move higher. Such a move higher could be devasting for the stock market and risk assets.
From one perspective, a stronger dollar would create an FX headwind for multinational companies and, as a result, negatively impact sales and earnings, causing growth rates to slow. But more importantly, a stronger dollar would lead to immensely tightening financial conditions, which would crush the recent stock market rally.
The dollar has a significant influence on financial conditions, coupled with a rising interest rate environment would create a hostile environment for risk assets. The dollar index has historically moved along with and influenced the Chicago Fed financial conditions index. When the dollar index rises in value, it, more often than not, coincides with the tightening of financial conditions.
The tightening of financial conditions is negative for stock prices because along with tighter financial conditions comes wider credit spreads and higher implied volatility, which both work to push stock prices lower. The weaker dollar and the easing of financial conditions have largely been the main drive of risk assets thus far in 2023, but that appears to be changing.
Technically, the dollar is close to a significant break out around the 103.50 level. That level would allow the dollar index to clear above a critical horizontal resistance level and also above a key downtrend from the March 8 peak. A break out above 103.5 could send the dollar index back towards March 8 and potentially higher in the weeks and months ahead.
Since the beginning of 2022, the S&P 500 has been trading inversely to the US Dollar (DXY), and when the dollar weakens, financial conditions ease and stocks rally. When the dollar rallies, financial conditions tighten, and stocks fall.
The conditions for the dollar to rise further would depend on two factors: The continued outperformance of the US economy over the rest of the world and interest rate differentials. The unexpected strength of the US economy has led to yields in the US rising faster than rates in other countries. One example is the widening spread between US and German 10-year rates, which favors the dollar over the euro.
This relationship is also true of the US dollar and the Japanese yen, with that FX pair following the spreads between the US 10-year and the 10-Year JGB. So if the spreads between US and sovereign rates continue to widen, it seems likely that the dollar can continue to outperform.
But importantly, if the dollar manages to push higher from its current levels, it is likely to inflict pain with credit spreads widening and higher implied volatility levels on the VIX, causing stock prices to go lower.
If the dollar does break out and starts to push higher, then the entire equity rally since May would be at risk, with the potential for it to be even worse, erasing all of the post-SVB gains since mid-March.
As noted, this entire equity market rally appears to have been driven by a short-volatility dispersion trade, first noted on July 16. This trade could only exist during a period of financial condition easing driven by a weakening dollar and falling interest rates. Since then, this short volatility trade has started to melt, as the dollar has strengthened and rates have risen, causing the VIX to push higher and the S&P 500 implied correlation basket to rise off of its lowest levels since 2018.
If the dollar strengthens further, this trade will continue to unwind further. But more importantly, the entire equity market rally comes at risk because a stronger dollar will lead to tighter financial conditions, and stocks and risk assets will not do well in that environment.