Wall Street absorbed the shock and economic disruption of Superstorm Sandy. And equity investors were prepared to make their peace with a status quo electoral outcome, with President Obama remaining at one end of the Mall and a divided Congress on the other. But one external force that stocks have not yet persuasively proven themselves inured to is a U.S. dollar that rises in value against other currencies.
The rise in the U.S. Dollar Index to a two-month high Wednesday is not in itself the driver of a stock sell-off that sent the Dow Jones Industrial Average plummeting more than 300 points at its nadir. But it is the dominant symptom of the broad flare-up in global market anxiety.
The largely as-expected U.S. election result left markets choppy but not radically changed overnight. In the pre-market hours, though, renewed focus on the still-fragile European economic condition, along with questions about the efficacy of the European Central Bank's rescue package, quickly surfaced.
Draghi Remarks Hit Markets
ECB President Mario Draghi highlighted the sagging economic performance in Germany, the financial stalwart of the continent, sending the value of the euro sharply lower against the dollar and hitting German stocks by nearly 2%. While Draghi also emphasized that the ECB's bond-buying program has unlimited capacity to buy member countries' government debt, fresh doubts about the unsteady course of European economic activity and plans for financial integration swamped investor risk appetites.
Since the financial crisis hit a crescendo four years ago, the dollar has generally moved in the opposite direction of stocks. As a result, nearly the entire doubling in U.S. stock indexes since the March 2009 bear-market lows has occurred during periods when the dollar was declining against other paper currencies and gold.
A strong dollar has been synonymous with credit-contagion fears, heightened economic slowdown risk, lower Treasury yields, weaker commodity prices, reduced chances of additional Federal Reserve monetary stimulus measures and — therefore — a rough road for stocks. This has complicated the stock market's reaction to some better-than-expected domestic economic news.
Addressing the financial implications of Tuesday's election a day ahead of time, Janney Montgomery Scott fixed-income strategist Guy LeBas suggests that, "from the markets' perspective, the prospects of future Fed action are not just the biggest but virtually the only issue, one that trumps regulation and the economic influence of either party's political platform. Nowhere is this more evident than in Friday's nonfarm payrolls numbers."
Those numbers, upwardly revised payroll growth in the summer months and a net gain of 171,000 jobs in October — nearly 50,000 more than forecast — contained "the most bond-unfriendly piece of news we've had in literally months," LeBas says.
Yet Treasury rates held firm, and the dollar gained ground, as perhaps the markets priced in a microscopically slimmer chance that the Fed's bond-buying plans will end in the fathomable future. Stocks couldn't hold an early reflex rally on the jobs data in the face of dollar strength, and they sold off hard into the weekend.
Familiarity Breeds Inevitability
This dynamic, placing risk assets such as stocks and commodities on one end of the macroeconomic seesaw and the dollar and Treasuries on the other, has become familiar to the point of seeming inevitable.
This need not be a permanent condition, though, and there are tentative hints of a potential turn. While the inverse relationship between stocks and the dollar has remained mostly in place, it has loosened a bit during the past year. The Dow is up 20% since its September 2011 low, set around the time of the Congressional debt-ceiling standoff and S&P's credit downgrade.
While that upside has come largely during months when the dollar was ebbing, the U.S. Dollar Index has managed to grind higher by 5% in the past year. Decent economic results in the U.S., relative to other G20 economies, have helped stocks and refocused attention on corporate health, while at the same time lending support to the dollar, as capital has been attracted Stateside.
This suggests that, eventually, the stock market could benefit from a dollar that rises for "the right reasons," i.e. an economy improving steadily to the point that permanent, ever-more-generous cash infusions by the Fed are no longer seen as necessary. The generally strong dollar in the 1990s derived not from some global bid for safe assets or a fear of a stingy Fed but from America's growth profile and productivity luring foreign investment.
Investors looking to gain confidence in owning stocks for the long term should not be wishing for the circumstances that would invite more-aggressive, dollar-weakening Fed action, such as another U.S. growth scare or a seizing up of global credit markets.
Yet, as today's action shows, such shifts in asset-market relationships don't tend to happen smoothly, with an in-stride passing of the baton, but rather in sometimes unnerving fits and jarring starts.