How The USD Explains (And Predicts) Stock Prices

One important point of the New York Fed study is that it demonstrated the contractionary effects of a rising exchange rate through the trade channel. American consumers and importers share the benefits of cheaper imports when the USD rises:

A stronger dollar makes U.S. imports relatively cheaper than domestically produced goods, which pushes consumers to substitute towards imported goods and provides firms with relatively cheaper inputs from abroad. Though both consumers and importing firms benefit from lower import prices, the data show that the extent of the benefit is limited because exchange rate movements are not fully passed through into prices seen by U.S. buyers. We estimate that a 10 percent rise in the dollar results in a 3.8 percent decline in nonoil import prices. Instead of adjusting prices charged to U.S. consumers by the full exchange rate change, firms exporting to the United States adjust their profit margins. Because import prices do not adjust by the full extent of the appreciation, the increase in demand for import quantities in response to the appreciation is moderated. The New York Fed trade model suggests a 10 percent appreciation of the U.S. dollar in one quarter (which then persists) results in 0.9 percent increase in real import values, as shown in the table below.

On the other hand, exporters get hurt because their margins get squeezed:

On the export side, a stronger dollar makes the price of U.S. exports more expensive when converted into foreign currency terms, reducing U.S. export growth. In order to try to maintain competitiveness, U.S. firms adjust their markups rather than pass on the full exchange rate appreciation into foreign prices. That is, U.S. exporters take a hit on their profit margins in order to maintain market shares. The New York Fed trade model suggests that a 10 percent appreciation of the U.S. dollar is associated with a 2.6 percent drop in real export values over the year. Consequently, the net export contribution to GDP growth over the year is 0.5 percentage point lower than it would have been without the appreciation and a cumulative 0.7 percentage point lower after two years.

In other words, a rising USD has a similar effect as raising interest rates. The strengthening exchange rate has, in effect, done some of the Fed`s tightening work for it. If it were to raise interest rates this year, the US economy would suffer the double whammy from the effects of rising currency and rates. Moreover, the divergent path taken by the Federal Reserve compared to the other major central banks of the world would put further upward pressure on the US dollar.

Jim Paulsen of Wells Capital Management, in the link above, expressed concerns that, unlike previous episodes when the Fed raised rates, the markets may be caught off-guard this time.

Several aspects surrounding today’s stock market make it appear abnormally vulnerable as the Fed begins the process of finally raising interest rates. First, the current price/earnings (P/E) multiple is among the highest of any Fed initiation cycle. Second, investor sentiment is probably a bit too calm since the stock market has not experienced a correction for more than 900 trading days, the third longest in post-war history. Third, the Fed begins this tightening cycle from the lowest unemployment rate of any post-war recovery. Finally, tightening begins when corporate profit margins are near historic highs and while earnings growth is already well past its best growth rates of the recovery.

Perhaps the stock market will be little affected by the Fed finally lifting interest rates from zero. However, these notable vulnerabilities suggest at least some period of stock market turbulence as the Fed begins to normalize monetary policy.

You would think that a September rate hike has been well telegraphed and priced into the markets, but Marc Chandler made the following observation:

Surveys suggest that a little more than 80% of the economists expect the Federal Reserve to hike rates in September. The September Fed funds futures, the most direct market instrument, has only about a 50% chance discounted.

In addition, there have been numerous warnings about the possible emerging market contagion effects from rising US rates. The IMF fretted about this issue in a publication, Spillovers from Dollar Appreciation (emphasis added):

The recent strong and sustained appreciation of the U.S. dollar (USD) raises questions about possible financial spillovers to emerging markets (EMs). The global economy is steering away from the Great Recession, but the recovery is still uneven, with marked divergences in the pace of growth among major economies. Specifically, the U.S. economy has gathered strength, suggesting a normalization of Federal Reserve monetary policy in the next few months. In contrast, growth in the euro area and Japan is still subdued, and their monetary policies are easing further. Reflecting these divergences in the outlook and expected monetary policies, the USD has appreciated considerably against most major currencies, especially the euro and the yen, over the past year. The USD has also strengthened vis-à-vis most emerging market currencies, particularly those of commodity-exporting economies. Historically, periods of sharp USD appreciation have been associated with an increased number of external crises in emerging markets—hence a key concern relates to possible spillovers from a sustained period of USD appreciation on the financial stability of EMs, specifically through effects on global capital flows, exchange rates, and EMs’ balance-sheet exposures.

The most glaring problem is the USD carry trade that will have to be unwound. In my previous post The key tail-risk that the FOMC missed (and you should pay attention to), I had highlighted a Bloomberg report indicating that there was about $9 trillion in offshore USD loans sloshing around the global financial system (emphasis added):

When Group of 20 finance ministers this week urged the Federal Reserve to “minimize negative spillovers” from potential interest-rate increases, they omitted a key figure: $9 trillion.

That’s the amount owed in dollars by non-bank borrowers outside the U.S., up 50 percent since the financial crisis, according to the Bank for International Settlements. Should the Fed raise interest rates as anticipated this year for the first time since 2006, higher borrowing costs for companies and governments, along with a stronger greenback, may add risks to an already-weak global recovery.

The dollar debt is just one example of how the Fed’s tightening would ripple through the world economy. From the housing markets in Canada and Hong Kong to capital flows into and out of China and Turkey, the question isn’t whether there will be spillovers -- it’s how big they will be, and where they will hit the hardest.

FT Alphaville pointed out that these loans are offshore loans and are beyond the control of the Federal Reserve:

But we’re now at a point where, unless all those external debtors have an organic way to keep dollars flowing into their coffers — i.e. without dependence on financing from non-US dollar pool sources — the value of all those loans, as well as the external US dollar pool itself, could quite abruptly and violent collapse in value.

To summarize the case for how the USD drives markets. The strength in the USD has had a negative effect on US growth (NY Fed) The markets may not be fully prepared for when the Fed actually raises rates because of high valuation, excessive investor complacency and the fact that the Fed may be behind the curve (Paulsen). In addition, there is a vast USD 9 trillion in offshore USD loans to EM credits that create a high degree of vulnerability with unknown contagion effects (IMF and others).

Despite all these potential negatives, the Trend Model has improved from a "risk-off" reading to "neutral", largely because of an improving Europe. As the chart of the STOXX 600 shows, European stocks rallied on the news of a resolution of the Greek impasse and the index remains above both the 50 and 200 dma. These signs of market strength shifted the composite model from negative to neutral.