The word out there is that U.S. stock markets are struggling because they are waiting for a trade deal. The real reasons are a strengthening dollar and increasing demand for bonds.
There is a multitude of things that impact the movement of stock markets, although the currency market isn’t usually one that comes to mind that often with investors. The effect and the impact of the U.S. dollar versus other currencies does vary.
The current impact of a rising dollar on stock markets is one of those that is very correlated, and as the Dow has put in its fifth consecutive losing session, the EURUSD pair, which goes down in price when the dollar strengthens versus the euro, has declined in an almost identical way.
As it turns out, this also corresponds to the quantitative easing by the European Central Bank. This is because this policy involves the central bank buying European bonds and driving both their price up and their yields down, which makes other bonds such as U.S. treasuries more attractive. People buy more of them, in U.S. dollars, and this increased demand in the currency puts its price up and makes it more valuable relative to the euro.
Even though the dynamics between currency pairs can differ, the dollar tends to move similarly against all currencies, due to the weight that the U.S. side has on the currency relationship. More people buying all these U.S. securities therefore raises the level of the water generally.
Large U.S. companies, through their exports, get paid a lot of their money in other currencies. While a dollar last week is still a dollar today, if they get less of it from a given sum in a different currency, this certainly changes the deal for companies to some extent.
Long-term investors may not care that the dollar is performing strongly this week, or care much about anything that is of such a short-term nature, but no matter how short the time period is, someone cares, and these people do trade in the markets and this caring gets expressed by increasing or decreasing demand for a stock.
Anything that changes the outlook with a stock, if acted upon, will change the supply and demand dynamics of it. Companies that do not do any exports aren’t affected by short-term currency fluctuations like this, but a lot do, especially ones that are part of an average like the Dow.
Europe Easing Monetary Policy is Not Good News for U.S. Stocks
It’s not just today or tomorrow that people look at with this move, and deviations with the value of the dollar will be treated differently depending on the cause of the fluctuation. In this case, when we’re talking about European monetary policy, this is the sort of thing that takes us beyond the normal ups and downs of currency and actually consists of a strategy that ends up increasing the value of the dollar and the value of exports to U.S. companies.
With this issue, there’s also the matter that the European Central Bank believes that economic conditions have deteriorated to the extent that these actions are warranted, meaning that the expectation is that U.S. companies will not only receive less for what they sell there, they will sell less of it as well due to declining demand in goods and services that this stimulus seeks to address.
The reason why there isn’t a strong inverse correlation between stock markets and the dollar’s value is because this is just one of several factors that move stock markets. If there’s nothing else major to move them, concerns about the dollar will step up and do the whole job itself.
We can also see positive correlations between the dollar and stock markets, when the cause of the dollar rising is something that stock markets actually like, more people buying U.S. stocks with foreign currency, and while the export concerns are still there, the negative effect on supply and demand of stocks can be easily overcome by this increased demand, which has a direct and more profound impact upon stock prices than these worries about export revenues.
In This Instance, The Dollar Strengthening is Bad News for Stock Markets
We have a negative correlation working this time, because the dollar isn’t strengthening due to people buying stocks but by instead buying bonds. Its impact is so transparent because there really hasn’t been a whole lot in the news this week, other than our seeing a flight to bonds over the last 5 sessions, which of course has a constricting effect upon stock prices.
When the demand for bonds go up, this money has to come from somewhere, and a lot of it comes from the proceeds of closing stock positions. This serves to increase the supply of stocks and cause them to trade lower.
These two factors, the advancing dollar and the increased demand for bonds, have teamed up to cause us to have a bearish week so far, and there doesn’t seem to be much on the menu to replace this other than seeing a U.S.-China trade deal get done. When the prospects of this was running the show more, this optimism did drive stock prices up, but this optimism has been completely drowned out by the dollar and bond markets this week.
This is because the current level of positivity about this deal is already priced into stocks, and it’s only when we get more good news that we have the real potential for more impact. Things have been pretty quiet this week though on this front, leaving us with the potential positive impact of this deal stepping aside and allowing these two negative influencers to act relatively unopposed.
We can therefore watch the EURUSD and the Dow go down hand-in-hand, day after day, and not really be surprised. Like with any news though, its impact gets priced into stock markets and things do settle in while people wait for more news.
We could then say that the market has already taken the punch from this, from the fears that were traded on as the situation developed, to now seeing the policy change announced, but we can still keep an eye on how the dollar is trading to gain some more insight as the extent of any further damage this situation may involve, if any.
We need to realize though that these things can create their own momentum, where for instance, people sell their stocks because they are worried about this, the stock price goes down, and more people sell because they are worried that the stock’s price is going down.
As some point this does tend to be offset by the increasing buying interest that lower stock prices in themselves create, which ends up concluding the story that inspired all of this. A lot of this has already been told and digested though, and therefore its impact should wane, where it will be then the turn of another issue or issues to guide us to wherever we are heading next.