The Dollar Is Undergoing A Major Change In Behavior, And Almost No One Has Noticed

Morgan StanleyIn recent years, the story has been that a weak U.S. dollar was good for U.S. stocks. The rationale was that a weak dollar makes American goods cheaper to foreign buyers.

However, that trend has reversed meaningfully since the beginning of the year.

From Morgan Stanley's FX team (emphasis ours):

While the market has focused on how the change in global monetary policy is impacting the JPY and GBP, we would also suggest that the USD is undergoing a significant change in behavior as a result of global monetary policy shifts. Until now, this has been largely overlooked, but we are increasingly of the view that investors will start to see the US has an investment destination, reducing the USD’s traditional funding currency status. Indeed, the USD has outperformed since the beginning of the year, in what would traditionally be seen as a broadly risk positive environment. Equity markets globally rallied strongly, with US equity markets leading the way, allowing the Dow to reach record new highs. This outperformance of US asset markets is a positive for the USD in the current environment, in our view.

In fact the USD has become increasingly positively correlated to the performance of the equity market. This suggests that the USD is not being used as a funding currency to the same degree as previously, and is starting to display some of the characteristics of an asset currency. This is consistent with the view that Fed policy stimulus is driving US asset markets, rather than broader risk appetite.

It appears that everything is starting to make intuitive sense. If the U.S. is in good shape, then its stocks and its currency will do well too.

Morgan Stanley adds that we should keep an eye on the labor market data since monetary policy is now being guided by it.

This theory is likely to be put to the test with the release of the US labour market data. With the Fed targeting the unemployment rate, the already important US labour market report takes on extra significance. Some of the initial labour market surveys over the past week have been providing encouraging signals, but it is the equity market reaction to the data that will be important. A continuation of the equity market rally on improving labour market data in the US is likely to keep the USD supported.

Here's another look at the relationship between stocks and the dollar. As you can see, the negative correlation has almost completely disappeared.