Why a rising dollar could sink stocks, but help the Fed

Microsoft Corp. is not the only US company to point to the soaring dollar as a potential problem.

A strong dollar has been a hot topic this week since software giant MSFT,
and Salesforce Inc. CRM,
highlighted the challenges that the currency poses for profits. It has also been reported in other industries including Pfizer Inc., PFE,
eBay Inc., EBAY,
and MasterCard MA,
since overseas sales may be affected by a strong greenback.

“The dollar’s strengthening has been a story for some time,” said Dec Mullarkey, managing director of investment strategy and asset allocation at SLC Management, pointing to the dollar’s recent DXY climb to near 20. years, 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 goods internationally, which can hurt the stock market. But cheaper, robust dollar imports are helping U.S. consumers, the engine of the economy, especially as households face high costs for gasoline, groceries and more.

“The strong dollar helps contain inflation,” Mullarkey said. “It’s essential with energy prices where they are.”

The two sides of the dollar

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

“The 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 most important battle people need to consider is the Fed’s fight against inflation,” Alankar said. “At the end of the day, whether the Fed can beat inflation will ultimately determine whether markets recover or not.”

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

Barclays analysts called the appreciation of the dollar, along with inflation, “notable market momentum that showed little sign of abating,” in a Friday client note. As long as the dollar continues to rise, the team expects the spotlight to shine even more on the currency in upcoming corporate earnings reports.

Analysts have already found that the direction of about 20% of companies (see chart) in the S&P Composite 1500 SP1500 Index,
discussed FX as a headwind in earnings calls this year, nearly double from a few quarters ago.

Management increasingly sees the change 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 drop from recent quarters. The S&P 1500 index covers approximately 90% of the market capitalization of the US stock market.

Investors sought safety in havens like US Treasury debt TMUBMUSD10Y,
and dollars this year as stocks and other risky assets fell on fears the Fed might go too far in its fight against inflation and trigger a recession. Another concern is that the high cost of living could spin out of control for a while, potentially triggering longer-term carnage in the economy.

“All the Fed is doing is trying to slow inflation down,” said Jack McIntyre, portfolio manager for Brandywine Global Investment Management’s global fixed income strategy. “But they don’t do it without slowing the economy and hurting stocks.”

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

In a heartbreaking 2022 for equity and bond investors, total returns for LQD-grade U.S. corporate bonds,
were negative 12.1% for the year to Friday, and minus 8% for high yield, HYG,

according to Mizuho Securities.

McIntyre expects the Fed to continue tightening financial conditions until inflation declines from its 8.3% annual rate in April to 3%.

“It comes down to the fact that the Fed is in a tough spot,” he said by phone. “To break the back of inflation, you need to tighten policy until it happens.”

US equities returned to a brief post-Memorial Day rebound to end the week in the red, with the S&P 500 SPX index,
recording a weekly loss of 1.2%, the Dow Jones Industrial Average DJIA,
down 0.9% and the Nasdaq Composite Index down 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. Data on housing and unemployment insurance claims will be released on Thursday. But the most important will be the publication on Friday of the consumer price index for May.

Lily: Fed will only need to raise rates to 3% to calm inflation, big bank economists say

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