The U.S. dollar has slowly been approaching a key exchange rate, which could have an unpleasant impact on the stock market. The currency is now perilously close to a level that some analysts believe could spell trouble, especially for a specific stock market segment. With certain factors in play, market observers expect the gradual upward trajectory to persist. If you’re involved in the markets, keep a close eye on the dollar while at the same time exercising caution with this particular category of stocks.
What’s Driving the Relentless Dollar’s Strength?
One key factor that has been driving steady dollar strength is the difference in central bank policy stances between the U.S., the EU, and other nations. While the U.S. Federal Reserve is likely to hold interest rates steady, the European Central Bank (ECB) is indicating its inclination towards lowering rates shortly. Globally, investors worldwide would then favor assets offering better interest rate returns, making U.S. dollar-denominated investments more appealing. As a result, demand for dollars would continue to rise, further increasing its value.
Currently, the U.S. Dollar Index (DXY) has seen a modest increase of over 3% from its early March lows, but it now sits in this upward trend between 105 and 106. This index gauges the strength of the dollar as it measures the dollar against a basket of major currencies. According to FX traders, 106 is a key level. This is because historically, when the DXY reached 106, the dollar faced selling pressure.
If the dollar can break above this resistance and stay there, it could signal a sustained period of dollar strength. This rise is attributed to the growing attractiveness of U.S. fixed-income investments, as yields on long-dated U.S. debt rose above those in other major economies like Germany, Japan, and the U.K. As mentioned, the need for investors to hold dollars to be involved in these investments has contributed to the currency’s strength.
The DXY is currently at a crucial point as it approaches the 106 level, which it couldn’t surpass in 2022 but briefly exceeded in October 2023. If it breaks through and maintains its position above this resistance point, foreign exchange traders may expect further upside.
Strong Dollar Weakens U.S. Corporate Earnings
The challenge for corporate America with a strong dollar is that it makes U.S. exports less competitive, reducing sales, and weakening corporate earnings. This would greatly impact some of the largest U.S. companies that rely heavily on overseas sales.
When the dollar strengthens, it makes it more difficult to sell to nations with declining currencies. This is because the cost of goods after exchanging into the local currency becomes more expensive in foreign markets. Alternatively, if U.S.-based corporations reduce their prices to sell their goods, it is a direct hit to corporate earnings. Either way, this translates to lower profits on financial statements, which can lead to stock price declines.
Dollar Strength and Stock Market Vulnerability
The strengthening DXY negative impact is particularly pronounced for companies that generate a large portion of their revenue from outside the U.S. Examples include household names like Apple (NASDAQ:AAPL), Nike (NYSE:NKE), and McDonald’s (NYSE:MCD). In fact, companies heavily reliant on overseas sales represent a significant chunk of the S&P 500 (SPX) – nearly 15% of its total market value.
The stock market has so far been surprisingly unfazed by the recent rise in the dollar. However, if the dollar breaks above the key resistance level of 106, investors may start to price in the potential for weaker corporate earnings. This could trigger a sell-off in stocks, particularly in sectors most exposed to a strong dollar.
Key Takeaway
In summary, 106 on the DXY is considered the breaking point of the U.S. dollar by many market participants and economists. While the recent dollar strength hasn’t dented the stock market yet, the future trajectory of the dollar and its impact on equities remains a key concern.
If the U.S. dollar continues to climb, especially if it breaks above 106 on the DXY, investors, particularly those holding stocks in dollar-reliant sectors, should be prepared for potential headwinds.
