The Federal Reserve has pivoted to a dovish-minded policy, yet that doesn't appear to have stopped the U.S. dollar.
The U.S. Dollar Index, which measures the value of the dollar against a basket of six major currencies, just hit a two month-high, which also happens to be close to a two-year high.
The strength of the greenback has come largely at the expense of the euro, which has a 57.6% weight in that index. No other currency is even close. The Japanese yen, with a 13.6% weight, is the second most-heavily weighted currency in the U.S. Dollar Index.
The disproportionate weighting is one reason why economists -- and the Federal Reserve -- prefer to look at the Federal Reserve's Broad Effective Exchange Rate Index to gauge what effects currency swings might have on economic activity.
The latter point notwithstanding, the leaning of the U.S. Dollar Index is still informative, particularly at this time as it conveys a picture of relative weakness for the eurozone economy that has been painted in broad brush strokes by weak data.
The weakness in the eurozone has availed itself in recent months, yet it came together in a collective fashion with the release this week of preliminary fourth quarter GDP data. The broader eurozone economy managed a 0.2% quarter-over-quarter increase that matched its equally torpid third quarter performance.
Germany, meanwhile, reported a preliminary 0.0% quarter-over-quarter change in GDP that came on the heels of a 0.2% quarter-over-quarter decline for third quarter GDP. That isn't much to cheer about, unless one wants to relish the thought that the German economy escaped falling into the grip of a technical recession, which is defined as two consecutive quarters of negative GDP growth.
It's little wonder that the euro has been flagging along with the eurozone economy. The support structure of a strong economy isn't there, which means, consequently, that the European Central Bank can't -- and won't -- raise its key interest rates anytime soon.
That ultra-low, and negative, interest rate complex is an albatross around the neck of the euro and a talisman for the U.S. dollar, which has been afforded its strong position by the relative strength of the U.S. economy and a higher interest rate complex.
The understanding today that the Federal Reserve is going to be patient before making its next interest rate move hasn't counted against the dollar to any great extent, because:
- The U.S. economy is still growing faster than many other developed economies.
- Interest rates here are still much higher than they are in Western Europe and Japan.
- The U.S. stock market is still outperforming.
- The U.S. is still a great place to invest given its relative political stability, rule of law, industry leadership, and liquid capital markets.
The strength of the dollar has consequences, though -- some that are good and some that are not so good.
The good consequences include:
- It helps hold down inflation, as it makes the cost of imported goods less expensive and applies pressure to dollar-denominated commodity prices.
- It makes it more affordable for U.S. citizens to travel abroad.
- It raises the appeal of owning U.S. assets, which attracts foreign capital and improves growth prospects.
The bad consequences include:
- It makes it more expensive for foreign holders of dollar-denominated debt to repay that debt.
- It can lead to capital flight that spurs volatility in emerging markets and a possible contagion effect.
- It creates competitive pressure for U.S. exporters.
- It crimps earnings prospects for U.S. multinational companies.
Both the Treasury market and the stock market have appreciated the implications of a stronger dollar on the inflation front. The tie that has bound both markets is the recognition that low inflation will keep the Federal Reserve from raising interest rates.
The stock market, though, can't ignore the fact that the strong dollar is an earnings headwind for companies doing business outside the United States. It is an added headwind, really, considering weaker demand abroad will result in reduced sales activity.
What It All Means
Last week we discussed how the stock market and Treasury market were marching to the same beat, but with different drummers. This week is a continuation of that narrative, as it is becoming increasingly apparent why market rates have barely budged in the face of an epic stock market rally.
The strong dollar is the tell, and what the euro is screaming in its ear is that the eurozone isn't in a good economic spot nor is it expected to be soon.
That assessment was seemingly validated by European Central Bank board member Benoit Coeure on Friday when he acknowledged, according to Reuters, that a new targeted refinancing operation for eurozone lenders is possible and being discussed. Mr. Coeure said so on the back of an admission that the slowdown in the eurozone is more pronounced than previously expected, which is likely to lead to a shallower path of inflation. Translation: advantage U.S. dollar.
The strength in the dollar will contribute to downward earnings revisions, which could roil the stock market at some point. That point doesn't appear to be now, however, because the U.S. economy isn't throwing off signs of sputtering like the eurozone economy.
Accordingly, the stock market isn't being upended by the dollar's strength so much as it is being supported by the euro's weakness, which is a reminder that the U.S. is still a relatively good place to invest.