Weekly Market Commentary - The Dollar's Ripple Effect
Using intermarket analysis is important to reduce the risk of missing vital directional clues within the financial markets. Recently, a strong U.S. dollar has created headwinds for theeuro, crude oil, and commodity-sensitive emerging markets.
THE DOLLAR’S RIPPLE EFFECT
In technical analysis, “intermarket analysis” looks at the way in which various markets interact. Intermarket analysis primarily looks at four market sectors: currencies, commodities, bonds, and stocks. From a technical analyst’s perspective, focusing our attention on only one market without considering what’s happening in the others leaves us in danger of missing vital directional clues and potential profits. The dollar, which has appreciated 24.4% since June 30, 2014 (as of March 19, 2015), has had an unusually strong intermarket effect of late. Today, we look at the dollar’s recent impact on other major markets and what it means for investors from a technical perspective. Since June 2014, a strong U.S. dollar has created a tailwind for European equities, while creating headwinds for the euro and commodities, especially crude oil, as well as equity markets for commodity-exporting emerging market countries such as Brazil. (To read about the dollar’s impact on domesticequity markets, see the March 16, 2015, W weekly Market Commentary, “Dollar Strength Is a Symptom Not a Cause.”)
CURRENCY RIPPLE EFFECTS
The strength or weakness of the U.S. dollar, as measured by the U.S. Dollar Index, is determined by the dollar’s value against a basket of major world currencies.As of March 19, 2015, the euro made up 57.6% of the U.S. Dollar Index. A strong dollar, therefore, generally corresponds to a weak euro. Technically, the U.S. Dollar Index has been operating in a bullish price trend, as represented by a positively sloping 40-week simple moving average [Figure 1].
The magnitude of its price move higher since July 2014 may be considered substantial, reflected by a weekly 14-period relative strength index (RSI ) value of 74 [Figure 2]. The RSI (14) is a technical momentum indicator that compares the magnitude of gains to losses over the last 14 trading periods. For the RSI (14), any reading above 70 is considered a strong, possibly overbought, uptrend; any reading below 30 is considered a strong, possibly oversold, downtrend.
Conversely, related weakness in the price of a euro in dollars (EUR-USD) has pushed the euro into a bearish weekly price trend, as represented by a negatively sloping 40-week simple moving average. The euro’s move lower may be considered substantial, reflected by a weekly RSI (14) in oversold conditions at 27, the weakest value since May 2010 [Figure 2, page 2]. A weak euro (and strong dollar) have supported European equities, represented by the MSCI Europe Index [Figure 3], with the strong negative trend for the euro, as measured by an oversold weekly RSI (14), matched by a strong positive trend for the MSCI Europe Index with an overbought weekly RSI (14) [Figure 4].
Currently, we expect the dollar uptrend (and euro downtrend) to remain intact from a technical perspective. However, the trend and RSI (14) indicators are showing potentially overbought conditions, which does increase the potential likelihood of a future trend reversal. Nevertheless, the trend will be considered intact until we see lower highs and lower lows in both the weekly dollar index and the RSI (14). This trend change would be further confirmed by the price crossing below its 40-week simple moving average. A trend change in the U.S. Dollar Index may potentially present an investment opportunity in the euro.
COMMODITIES AND EMERGING MARKETS RIPPLE EFFECTS
The dollar can also impact commodities and emerging markets (EM), especially those that are large net commodity exporters. For example, as the dollar has climbed, we have seen the price of crude oil move lower, as well as commodity exporters such as Brazil. However, not all EM countries are following crude oil lower (and not all EM countries are big commodity producers). For example, the Shanghai Stock Exchange Composite Index has been trending higher with the dollar, as China’s economy benefits from lower oil while Brazil’s economy is dependent on oil exports [Figures 5, 6]. A potential reversal lower in the dollar could drive crude oil higher. Rising oil would increase the likelihood that the MSCI Brazil Index would move higher and the Shanghai Stock Exchange Composite Index would move lower.
EUROPE: TO HEDGE OR NOT TO HEDGE
The improving technical picture for Europe, coupled with improving economic data, has led us to become more positive on the region. The weak euro is helping drive Eurozone exports, while quantitative easing (the European Central Bank’s bond purchase program) is helping to increase confidence that the central bank will be able to generate desired inflation (and stave off deflation). And although valuations have become more expensive following recent gains, they remain cheaper than those in the U.S.
Should those considering adding European equity exposure hedge currency? We would say yes at this point, given the likelihood that the strong dollar uptrend may continue. By hedging the euro, an investment in European stocks may benefit from the weaker euro’s positive effect on European exports, while not detracting from the returns realized due to the currency translation effects (investment returns overseas can be reduced by a strong U.S. dollar, due to currency translation for U.S.-based investors).
Beyond technical analysis, the dollar should continue to benefit from stronger relative economic growth in the U.S. compared with Europe, higher interest rates, and prospects for the Federal Reserve to begin raising interest rates possibly this fall, while Europe is adding stimulus. Moreover, historically, dollar uptrends can last a number of years (see last week’s Weekly Market Commentary, “Dollar Strength Is a Symptom, Not a Cause,” for more details).
Intermarket effects will change over time, but of late, dollar strength has had a significant impact on other currencies, commodities, and both emerging market and developed market equities. As part of our daily process we analyze the markets as a whole and are always looking for relationships that may provide profitable opportunities through the art and science of intermarket analysis.