The US Dollar Has Been a Trader's Cheat Code. Can it Last?

This morning before the market open I wrote in our team's newsletter that strength in the dollar was in conflict with gains in the Nasdaq and should be a red flag for recent equity dip-buyers. Stocks proceeded to get slammed throughout the day and QQQs finished at the lowest level of the month. Sign up here!

This isn't the first time we've stressed conflicting moves in the greenback and equity markets on the show. In fact, I'm kind of shocked more people haven't been pounding the table on how reliable the dollar has been for short-term traders the last three months. Assuming the inverse relationship between the two will hold, and fading the stock move when the two are in conflict, has worked like a charm.

Safe to say that cat's out of the bag after today.

The problem coming into today was that the dollar was breaking out of a two-month range while the Nasdaq was trying to break through an important level of resistance. Gold, which until recently had been trading very closely with the Nasdaq, was also under pressure. Commodities too. The Nasdaq looked like the one out of line.

The big question right now is how to describe the trajectory of the stock market. Are we still in the uptrend since March, or in a downtrend since the month began? There's not a lot of obvious technical answers, both are right; it all depends on where you place the goalposts. But if we look to the U.S. dollar for answers, it errs in favor of the downtrend.

First, the recent history. Since March, few relationships in the market have been more reliable than the inverse correlation between the dollar and U.S. equities. Its steady descent from dash-to-cash levels in March represented the bear-killing cocktail of unprecedented monetary support and economic stabilization that pushed investors toward U.S. growth stocks. As the Fed threw everything it had at the market and fiscal support helped restart the engine, the dollar's steep decline was inevitable, and for the most part, represented improving conditions. The exception was in late summer, when it looked like COVID could become a U.S.-specific problem, and gold bugs and bitcoin bros took the opportunity to make the case for currency devaluation and loss of reserve status.

Since then things have gotten more complicated.

Almost every major trend shift since then has aligned with strength in the dollar: gold's rally ended as the dollar stopped dropping (early Aug), bitcoin fizzled out as USD stabilized (mid-August), and the seemingly unstoppable stock run buckled as the dollar moved to the high end of its late-summer range (early Sep). Based on this timeline, we have a nice spectrum of which asset classes are most susceptible to the dollar.

It's a closely tied spectrum to the one that centers around the Fed. Despite all the hoopla over Jay Powell's ZIRP-forever promises, nothing the Fed Chair has said has meaningful weakened the dollar in two months. On Wednesday, he coyly said "we've done basically all the things we can think of." It's probably not a great move to bet against the creativity of the Fed, but at least one major catalyst for the dollar decline, and by transition, higher stocks, is on hold for now: new easy money from the central bank. That means that the dollar may be free to move more closely with the ups and downs of US economic data relative to the rest of the world.

It's possible the dollar and stocks could rally in unison, as they did in 2019, when the U.S. was the rock of a faltering global economy on the brink of a trade war. But don't forget, the Fed was cutting rates anyway, so the relationship between it all remains a bit confusing. That's why it's going to be crucial to see how the dollar responds to new economic data in the absence of incremental help from the Fed. Here are the options I see:

1) Data gets better and dollar moves higher: we can confirm the Fed played a big role in sinking the greenback the last six months. Not a bad scenario, but with mixed results for stocks as improving data is good for cyclical stocks but not as good for megacap tech stocks, which drive the overall market.

2) Data gets worse and dollar moves higher: the dollar still clearly represents the fear trade, almost certainly a bad scenario for stocks, barring more fiscal support. COVID impact particularly important in this scenario. Continued quarantine without fiscal support won't be good for much at all, Zoom and Peloton included. If there is offsetting fiscal support, possible second leg for tech growth trades.

3) Data gets better and dollar moves lower: this is most likely in the scenario that the global economy is improving alongside the U.S. Probably pretty good for everything, as long as it doesn't happen too fast, which could spike yields and cause valuation issues in tech.

4) Data gets worse and dollar moves lower: this is the least ideal, probably. Means that despite all our monetary and fiscal efforts, the economy is naturally teetering. Not good for stocks, possibly good for gold and bitcoin.