Why a strong dollar threatens a fragile stock market, but is a boon to the Fed

Microsoft Corp. isn’t the only US company to point to the rising dollar as a potential problem.

a strong dollar it’s been a hot topic this week since software giant MSFT,
-1.66%
Y Sales force meNorth Carolina. crms,
-1.85%
he pointed out the challenges the currency is causing for profits. It has also been singled out in other industries, including by Pfizer Inc., PFE,
+0.99%
eBay Inc., eBay,
-1.42%
and MasterCard MA,
-1.45%
as foreign sales may be hurt by a strong dollar.

“The strengthening of the dollar has been a story for a while,” said Dec Mullarkey, managing director of investment strategy and asset allocation at SLC Management, noting that the dollar DXY recent rise to almost a 20-year high, measured against a basket of rival currencies.

“It may be a pinch for business, but frankly, it’s good for the Fed,” Mullarkey said.

A strong dollar makes it more expensive for US companies to sell their products on the international market, which can hurt the stock market. But cheaper imports from a strong dollar help American consumers, the lifeblood of the economy, particularly as households face high costs for gasoline, groceries, and more.

“The strong dollar is helping to keep inflation at bay,” Mullarkey said. “That is critical with energy prices where they are.”

The two sides of the dollar

A strong dollar could also help the Federal Reserve achieve your “soft” landing for the economy as it works to cool inflation by sharply raising interest rates over the next few months.

“The whole purpose of monetary tightening, to drain liquidity, is also to strengthen a currency,” Ash Alankar, head of global asset allocation at Janus Henderson Investors, said by phone.

“The biggest battle people have to consider is for the Fed to fight inflation,” Alankar said. “At the end of the day, whether the Fed can beat inflation, ultimately that will determine whether or not the markets recover.”

The ICE US Dollar Index was up 6.5% in the year to Friday and up 13% from a year ago, according to data from FactSet. The dollar could gain more ground this year if inflation falls at a slower-than-expected pace, analysts at BofA Global said in a report on Thursday.

Analysts at Barclays called the dollar’s appreciation, along with inflation, “remarkable market dynamics that have shown little sign of abating,” in a note to clients on Friday. As long as the dollar continues to rise, the team expects the currency to shine even brighter in upcoming corporate earnings reports.

Analysts already found that management at roughly 20% of companies (see chart) in the S&P Composite 1500 Index SP1500,
-1.59%
have discussed the exchange rate as a drag on earnings calls this year, nearly double what it was a few quarters ago.

Management increasingly sees currencies as a headwind

Barclays Research, Refinitiv

They also found that only about 5% of companies in the index described a strong dollar as a tailwind, a sharp decline from recent quarters. The S&P 1500 index covers approximately 90% of the market capitalization of the US stock market.

Investors have sought safety in havens such as US Treasury debt TMUBMUSD10Y,
2,939%
and dollars this year as stocks and other risky assets have tumbled on fears the Fed will go too far in its control of inflation and spark a recession. Another concern is that high costs of living could spiral out of control for some time, potentially triggering long-term carnage in the economy.

“All the Fed does is try to curb inflation,” said Jack McIntyre, portfolio manager for global fixed income strategy at Brandywine Global Investment Management. “But they’re not doing it without slowing the economy and hurting stocks.”

Additionally, McIntyre said that uncertainty about the path to lower inflation “does not bode well for credit as an investment vehicle.”

In a harrowing 2022 for stock and bond investors, total returns on US investment-grade corporate bonds LQD,
-0.32%
were negative 12.1% in the year to Friday, and minus 8% for high yield, HYG,
-0.74%

jnk,
-0.77%
according to Mizuho Securities.

McIntyre expects the Fed to continue to tighten financial conditions until inflation recedes from its 8.3% annual rate, as of April, to the 3% range.

“It goes back to the Fed being in a tough spot,” he said by phone. “To end inflation, you have to tighten policy until that happens.”

US stocks pulled back a brief post-Memorial Day rebound to end the week in redwith the S&P 500 SPX index,
-1.63%
Posting a weekly loss of 1.2%, the Dow Jones Industrial Average DJIA,
-1.05%
falling 0.9% and the Nasdaq Composite Index losing 1% for the week, according to FactSet.

Next week, US economic data will include a consumer credit update on Tuesday, followed by revised wholesale inventory data on Wednesday. Housing claims and unemployment data will be released on Thursday. But the most important will be the release on Friday of the consumer price index for May.

Read: Fed will only need to raise rates to 3% to cool inflation, say economists at big banks

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