Dollar Decline: Stock Market Rally Explains 70% Of Recent US Dollar Downtrend, Says BofA

Since hitting an 11-month high in early October, the US dollar index (DXY) has fallen 3.8% and this has been largely due to investors backing the recent equity market rally, analysts at Bank of America said on Tuesday.

The dollar has long been regarded as a safe-haven asset. Keeping investments tied up in dollar assets during times of market upheaval has been among the classic “risk-off” trades, along with gold.

And the reverse is also true, as BofA analyst Adarsh Sinha indicated — saying most of the dollar sell-off has been down to the equity market rally, which saw the S&P 500 index climb 10.5% since Oct. 27 as investors have become more bullish on risk.

Also Read: Investors Ditch US Dollar At The Fastest Pace In A Year

Market Performance Indicates Higher Risk Appetite

The equity market rally has been driven by double-digit percentage gains in the shares of tech giants such as Microsoft Corp. MSFT and Apple Inc. AAPL while chip producer Intel Corporation (NASDAQ: INTC) has jumped 24% in the past month.

At the same time, the VIX index, a measure of equity market volatility also known colloquially as the Wall St “fear gauge” has fallen to its lowest levels since before the COVID-19 pandemic.

Dollar exchange-traded funds have also illustrated similar risk strategies: the Invesco DB US Dollar Index Bullish Fund UUP is down 3% since Nov. 1, while the Invesco DB US Dollar Index Bearish Fund UDN is up 3.8% over the same period.

“Over 70% of the estimated dollar move is attributable to the equity rally — better risk sentiment — with narrower U.S. rate differentials, lower energy prices and China optimism contributing only marginally,” Sinha said.

Dollar Decoupling

This focus on risk sentiment essentially decouples the dollar from its traditional drivers such as economic growth, rate differentials and geopolitical risk. But can the current euphoria in the equity markets keep the dollar down for long?

“In the weeks ahead we expect choppy activity as asset prices react to economic data releases in the hope of second-guessing Fed policy,” said Jane Foley, senior FX strategist at Rabobank.

Again, it will come down to the Fed. With markets pricing in a Fed rate cut by the end of the first quarter, dollar weakness could last into the New Year should equity markets enjoy a Santa rally.

So far, equity investors have largely ignored signs that a U.S. economic slowdown is gathering pace. The labor market appears to be loosening while manufacturing PMI is below the 50 level, which indicates economic contraction.

Instead of the implications on corporate growth, investors are focusing on what the slowdown means for the interest rate outlook.

“Factors other than the improvement in global risk sentiment need to drive the momentum from here,” Sinha concluded.

Now Read: VIX At Pre-Pandemic Low: Is Wall Street’s Fear Gauge Mispricing Risk Of Downturn?

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