Strength of U.S. Dollar and Concerns for Stocks

The U.S. dollar continues to show strength, as it rallies alongside Treasury yields, causing investors to worry about the possibility of interest rates remaining higher for a longer period than anticipated. This situation is posing more of a problem for stocks.

U.S. Dollar Index

The U.S. Dollar Index, which measures the currency against a basket of six peers, experienced a rise of over 0.2% on Tuesday, reaching above 106.2. However, it settled lower around the 106 level. Over the past five days, the index has seen a gain of 0.8% and is currently up by more than 6% since its July lows. It is now at its highest point since November 2022.

WSJ Dollar Index

Another metric used to measure the relative strength of the U.S. dollar is the WSJ Dollar Index. It measures the dollar against a wider basket of 16 currencies. On Tuesday, it recorded a 0.1% increase, marking its sixth consecutive day of gains.

While the dollar is still below its peak from 11 months ago (October 2022), when it reached its highest level in 20 years, its rapid rise in recent weeks should be a cause for concern among investors, especially considering its implications for the stock market.

Since the Federal Reserve's latest monetary policy decision on September 20, stocks have been slipping while bond yields and the dollar have been rising. Although the Fed decided to keep interest rates unchanged, it highlighted the possibility of further rate hikes in order to effectively control inflation. Fed officials are projecting rates to surpass 5% through 2024.

According to Raffi Boyadjian, an analyst at broker XM, "Investors are moving away from government securities and favoring cash due to expectations of potential further rate hikes in the U.S." This shift is driven by the idea that when rates increase, bond yields also rise. As a result, investors find it more attractive to invest in the U.S. currency to take advantage of the relatively higher risk-free returns on government debt.

The yield on the benchmark 10-year U.S. Treasury has surged above 4.5% since the Fed's meeting last week, reaching its highest level since 2007.

The Impact of Higher Bond Yields on Stocks and the Dollar

Higher bond yields can create problems for stocks. When the yields on safe Treasury bonds increase, investors are less incentivized to invest in riskier assets such as equities. This can be detrimental to multinational companies listed in the S&P 500 index since their profits, recorded in foreign currencies, are weakened when the dollar strengthens against its peers.

The rise in Treasury yields, however, is not the sole factor contributing to the strength of the dollar. A gloomy global economic outlook has also played a role in boosting the greenback. Government bond yields in various countries have rallied, but concerns over China's property crisis and the potential recession in European economies like Germany have weighed on rival currencies.

Investors should closely monitor the latest data release on Friday, particularly the core personal-consumption expenditures (PCE) index. This index is regarded as the Federal Reserve's preferred measure of inflation. Its outcome could serve as a major catalyst for shifting expectations regarding interest rates, bond yields, and consequently, the direction of the dollar.

According to Boyadjian, an expert in the field, the upcoming update on the inflation front will be crucial. If the core PCE price index, forecasted to drop to 3.9% in August, actually reflects this decrease, the rally in bond yields may potentially take a breather. This pause could halt the advance of the U.S. dollar.