Keep an eye on the dollar – Damien’s Market Update – February 2023

Welcome to the latest episode of my monthly YouTube show where I discuss what is happening in investment markets and what to look out for. This month I explain why it is important to keep an eye on the dollar.

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Abridged transcript - Damien's Market Update - February 2023

In the Money to the Masses Sunday podcast 398 I spoke about the importance of the US dollar index and how it can go a long way to explaining many of the market moves we saw in 2022. The US dollar index is a measure of the strength of the dollar against a basket of currencies. In 2022 the US dollar index rallied strongly, peaking in the Autumn before tumbling into the year end.

The US dollar index hit a multi-decade high in 2022 which became a headwind for US equities. But when the dollar weakened the US stock market rallied. A strong dollar not only tends to hit US stocks but also commodities (especially gold) as well as proving a headwind for Asian and emerging markets. In contrast, a strong dollar versus the Japanese yen tends to be positive for the Nikkei 225, while a weaker pound versus the stronger US dollar can provide some support for the FTSE 100. All trends we saw in 2022.

A change in the value of the US dollar index will not always immediately result in a textbook move in another asset's price, but with markets hanging on every move central banks make and the latest economic data, much of this has been reflected in the movement of the US dollar index. That’s why it’s important to pay attention to it.

In podcast episode 398 I explained how at the start of 2023 the US dollar index was attempting to break out of a downward sloping triangle that existed at the time. On the downside the 104 level was of particular importance. Go below there and the dollar weakness could accelerate and bring about a change in fortunes for most asset classes, compared to what they experienced in most of 2022. But if it could break higher out of the triangle then a potential dollar rally was on the cards. It is worth calling up a chart on your phone or desktop to see the movements of the US dollar index over the last year. Just search DXY. For those watching on youtube I’ve put the latest DXY chart up with some historic technical lines drawn on showing this triangle and what happened next. It only looks at daily prices to keep things simple but it is sufficient to highlight the over trends.

Fast Forward to today and the dollar index did indeed break below the key 104 level. The fall in the US dollar index led to a reversal or at least a significant change in many of the main trends experienced during the first nine months of 2022, when the dollar index powered to that multi-decade high. 

Emerging market assets were among the winners, as were US equities, which in recent weeks retested the downtrend line in the S&P 500 that's been in place since the start of 2022. The only difference this time is that the S&P 500 has finally broken out of that downtrend at the fifth time of asking. We've also seen bond yields tumble (meaning your bond fund holdings have finally rallied) and gold exploded higher. The price of gold rallied almost 5% in January before giving back some of those gains. Unsurprisingly the FTSE 100 and the Nikkei 225 lagged. Both indices face headwinds when their domestic currencies strengthen against the US dollar

So why has the US dollar continued to break down in 2023? It's because the US dollar index still reflects a lot of the investing narratives driving markets. Firstly, the market is pricing in a "Fed pivot," meaning lower US interest rates and is reflected by the weakening US dollar. A stronger euro, driven in part by a more hawkish European Central Bank, as well as China's economic reopening, have also added to the downward pressure on the US dollar. Less investor fear and more greed has also caused the dollar to weaken as investors shun its haven status. The famous CNN greed and fear index is now flashing extreme greed after only flashing fear just a month ago.

The big question is, has the US dollar got further to fall? The chart shown on screen, for those watching on youtube, shows the US dollar index's 50-day moving average line and the 200-day moving average line recently formed a death cross. This is when the 50-day moving average crosses below the 200-day moving average. It's supposedly an omen of further weakness to come. The last time this occurred was in July 2020, which marked the beginning of a significant downturn for the US dollar.

With the market consensus now seemingly for the US dollar to weaken further it appears that many investors have finally gone all-in and bet that inflation has peaked, central banks will stop tightening, begin easing once again and severe recession will be averted. Even on this side of the Atlantic the FTSE 100 has finally hit a new all-time high, after five years of trying, while European equities (as measured by the STOXX Europe 600 index) have rallied more than 20% from their autumn lows, marking the definition of a bull market. But if any one of the market narratives or assumptions, especially the Fed pivot, proves false, it could cause a shake up in the US dollar index, which in turn could unravel recent investment trends.

In fact in recent days we’ve had a demonstration of the fragility of the rally when stronger than expected employment data in the US sparked concern that the Fed might have more room to raise rates further in its fight against inflation, without derailing the economy. It caused the US dollar index to experience a sudden powerful rally, taking it from just above 101, to just below that key level of 104 and its 50 day moving average. This is proving a level of resistance and if the US dollar index can break above there and push on above 105 then we could see a reversal of the asset price moves we’ve seen so far in 2023, which would put the rally in US equities in particular under threat. If the US dollar index falls lower then bullish investors’ bets might just pay off.