When the Dollar Index does this, pay attention
Key points:
- The Dollar Index (DXY) increased by 10% over the trailing 126-day period
- Similar surges of this magnitude suggest the dollar can continue higher in the near term
- Commodities and stocks tend to struggle when the dollar rises, similarly to today
What happens when the Dollar Index surges by a meaningful amount
Let's assess the dollar, commodities, and stock market outlook when the 126-day rate of change for the Dollar Index (DXY) increases by 10%. I will use a reset that requires the rate of change to cross below zero before a new signal can trigger again.
The Dollar Index is up a meaningful amount over the trailing 6-month period and on the cusp of breaking out of a significant base formation.
Similar surges in momentum preceded positive returns for Dollar Index in the near term
This study generated a signal 20 other times over the past 48 years. After the others, the Dollar Index's future returns, win rates, and risk/reward profiles look solid in the 1-4 week time frames. And, more recent signals look even better, with 13 out of 14 winners at some point in the first month.
Similar surges in the Dollar Index preceded mostly negative returns for commodities
When I apply the dollar signal dates to the Bloomberg Commodity Spot Index, the outlook table suggests that a broad basket of commodities could struggle across short and medium-term time frames. Commodities use the dollar as a pricing mechanism for global trade. So, when the dollar strengthens, commodities become more expensive in non-dollar terms. When something becomes too expensive, demand dwindles, and price corrects.
Similar surges in the Dollar Index preceded mostly negative returns for crude oil
When I apply the dollar signal dates to crude oil, the outlook table suggests we could potentially see some relief at the gas pump.
The crude oil outlook table contains fewer signals due to data limitations.
Similar surges in the Dollar Index preceded mostly negative returns for copper
When I apply the dollar signal dates to copper futures, the outlook table suggests flat to negative returns across all time frames. On Tuesday, I shared a copper momentum study that highlighted a potentially challenging environment for the commodity. So, with this new information on the dollar, we need to be mindful that more unfavorable evidence is building that contradicts the bullish case for a continuation of the copper uptrend.
Similar surges in the Dollar Index preceded mostly flat to negative returns for gold
When I apply the dollar signal dates to gold futures, the outlook table suggests gold prices could show flat to negative returns in the 1-12-week time frames. However, I would note that more recent signals have been more favorable, especially in the 3-month window.
Similar surges in the Dollar Index preceded mostly flat to negative returns for stocks
When I apply the dollar signal dates to the S&P 500, the outlook table suggests large-cap stocks could struggle in the 1 to 26-week time frames. The S&P 500 index contains more constituents with a global footprint. Therefore, the adverse price action in the dollar can impact a company's earnings per share when local currency revenues convert to dollar terms. The phenomenon is known as a currency headwind, and we're starting to see more headlines with that phrase in the subject line.
Sector and industry returns show a contrast
The sector and industry group outlook confirms the cautionary stance for the broad market with tepid results from 1 to 12 weeks later. Not surprisingly, energy and groups with a more significant global footprint look unfavorable. I would also note that safe haven sectors like staples and utilities tend to outperform. The S&P 1500 industry group returns look better than the S&P 500 sector returns. I would keep in mind that the S&P 1500 contains more small and mid-cap issues with less foreign exposure. So, a potential currency headwind is less likely.
Similar surges in the Dollar Index preceded negative returns for global stocks
When I apply the dollar signal dates to a global index of stocks that excludes U.S. issues, the outlook table suggests global stocks could continue to struggle in the near term.
The global index outlook table contains fewer signals due to data limitations.
Similar surges in the Dollar Index preceded negative returns for emerging market stocks
When I apply the dollar signal dates to a basket of emerging market stocks, the outlook table suggests the MSCI emerging markets index could continue to struggle in the near term.
The emerging markets index outlook table contains fewer signals due to data limitations.
What the research tells us...
When the 126-day rate of change for the Dollar Index surges above 10%, momentum tends to beget more momentum for the dollar in the near term. Similar setups to what we're seeing now suggest that the dollar continues to rise, negatively impacting commodities and stocks across short to medium-term time frames. The sharp increase in the safe-haven currency is sending us a message and adds a new element to what is already a challenging market environment. We need to be even more diligent in managing risk.