Wednesday's Market Minute: Here's Why USD Could Be the Tell for Risk Unwind

Stocks continue to do roughly the opposite of what I think they “should.” I know, famous last words. The simple reason why I think stock prices should retreat – or at very least, repeat the type of unwinding we had in the first quarter – is that the three main sources of liquidity for markets the past two years are all simultaneously in retreat: monetary policy, fiscal policy, and personal income. The first one’s the most obvious, with the Federal Reserve gearing up to taper as we speak. Many would dispute my inclusion of fiscal policy as “drying up,” but the simple fact is that $1.7 trillion (assuming it arrives) is a notable drop-off from last year’s rate of government assistance. The rate of change in the stimulus is negative. This brings us to the third source of money flows into the market: personal income -- which is still rising -- but slowing due in no small part to its ties to stimulus. And not to be forgotten, inflation is eroding 5.4% per year according to the Consumer Price Index.

Liquidity is not coming out of the system, but it is going in at a slower rate. I think that matters. I’m not arguing the S&P 500 should be directly correlated with the Fed balance sheet like some; I’m saying that the rate of change of the balance sheet is likely an important factor and should have some impact as it reverses from its fastest increase ever.

This is why I think watching the dollar is going to be so important. The decline in the U.S. dollar was one of the most salient characteristics of the stimulus-driven Covid rally. There was no more reliable relationship in markets than dollar weakness on news of every additional policy measure. But ever since Fed officials started getting hawkish in June, the dollar’s been on the move. Most notable is its resilience in the face of an almost-certain $1.7 trillion coming down the pike courtesy of the White House. Despite that legislation inching closer last week, the dollar posted its biggest rally in 18 months on Friday.

Dollar futures are holding firm in a range below 95 but if the greenback rallies past that level it will mark the technical reversal of its long-term Covid era decline. If the dollar breaks out in the face of incoming new stimulus, it’s strong evidence in favor of my view above that liquidity growth is slowing at such a rapid rate that it is effectively acting like economic tightening in the system. Let’s watch.

Image by Gerd Altmann from Pixabay