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Stock market relief keeps US dollar pinned down


30 May 2022 Written by Marios Hadjikyriacos  XM Investment Analyst Marios Hadjikyriacos

The conversation in financial markets has changed dramatically in the past few weeks. Whispers of recession have replaced inflation as public enemy number one, thanks to a growing pile of evidence that economic growth is losing power. Cracks have started to show in the US housing market as soaring mortgage rates take a bite out of demand, while major corporations such as Amazon have announced plans to slow or freeze hiring amid a scramble to slash costs. It’s not just an American story either. China might already be in recession, the British economy is battling a severe slowdown, and the Eurozone is unlikely to stay immune for long. 

Dollar cools off

Bond markets have started to reflect these risks. Treasury yields have been losing altitude for most of the month as slower economic growth got baked into the cake and inflation concerns receded. The Fed could even hit the ‘pause’ button by September if the economy underperforms according to Bostic. 

All this has taken the shine off the US dollar and the question is whether we are in the early stages of a trend reversal. Admittedly, the fundamental picture hasn’t changed much. Most economies are in worse shape than America and a global recession would likely send safe-haven flows into the reserve currency, so this still seems like a correction in the broader uptrend. 

There are three fundamental catalysts that could trigger a trend reversal in the dollar - the Fed pauses its tightening cycle or China abandons zero-covid policies. Until then, calls for the dollar’s demise are premature. 

Riskier currencies bounce with stocks

As always, a sinking US dollar lifted all other boats in the FX market. Dollar/yen has mirrored the slow grind lower in Treasury yields and there might be more relief in the pipeline amid speculation the Bank of Japan could adjust its yield curve control strategy now that inflation has started to fire up. Similarly, the British pound and other risk-sensitive currencies have enjoyed a nice rebound. One could argue the fundamental outlook for sterling has gotten worse with the latest UK business surveys foreshadowing a sharp economic slowdown, so this latest recovery seems linked to the improving mood around equities. 

Stock markets have been trading like a pinball machine, with the S&P 500 rising by almost 10% in just over a week after the index dipped its toes in bear market territory. Many attribute this stunning recovery to Fed bets being dialed back a notch amid signs inflation has peaked. 

However, that’s not very convincing. If the Fed’s trajectory is really being recalibrated because of economic slowdown concerns, equities should be feeling the pain too as earnings estimates get revised lower. Instead, this seems mostly like a relief bounce, driven by oversold conditions and short-covering.  

Oil prices and upcoming events

In the energy arena, oil prices continue to march higher as demand shows no signs of cooling and supply remains constraint. Windfall taxes on the profits of energy companies like the UK has imposed could even make the situation worse by discouraging new drilling and investment in the industry. 

On the bright side, the Biden administration has hit the panic button ahead of the US midterm elections, sending diplomats to Saudi Arabia for 'secret talks' to boost production. 

There isn’t much on the agenda for today, with only German inflation data on tap. US markets will remain closed for the Memorial Day holiday, so liquidity will be thinner than usual. The rest of the week includes a Bank of Canada meeting and the latest US employment report. 

By XM.com
#source

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