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  • The U.S. Dollar rally is slowing demand for U.S. products and services overseas.
  • Converting foreign sales back into U.S. Dollars results in smaller profits.
  • Rising bond yields are competing against stocks for assets.
  • A higher risk-free rate of return forces valuation models to penalize stocks. 
  • Higher yields increase variable interest expenses while also slowing revenue growth.

You're not alone if you’ve found yourself on the wrong side of the market at some point this past month. The stock market has been churning sideways since late September. For example, the S&P 500 ETF  (SPY)  was trading at roughly $370 this morning, a level it also tagged on September 23rd. The same is true for the NASDAQ 100, Russell 2000, and S&P 400 Mid Cap ETFs.

Unfortunately, those indexes haven’t moved in a horizontal line. Instead, they’ve chopped violently higher and lower, leaving buyers and sellers equally unhappy.

The recent action might have you wondering what will happen next. While crystal balls are hazy, a strong dollar and weak bond prices have been a big headwind to stocks. If that changes, stocks may be able to break out of their recent range and head higher. If not, stocks could fall further.

A key time to watch the Greenback

In “The U.S. Dollar Holds the Key to Unlocking Almost All Assets,” Real Money’s Carley Garner points out that the U.S. Dollar Index is flirting with key resistance. The index has traded above resistance near 113.4 intraweek; however, it’s yet to close above it on a weekly basis.

Garner writes:

“Historically, the dollar has been known for dramatic tops. The last three tops have followed a trendline that dates back to 2016, which currently lies near 113.40. We've been watching this level for weeks as a potential area of reversal. Our analysis was looking for a weekly close above or below this line to confirm either a dollar top or a continuation to the all-time-high price of 120.00. Thus far, the dollar index has not been able to close above 113.40, but it has spent some time above the pivot price on a temporary basis.

As long as this continues to be true, as we expect, the dollar index will become progressively more susceptible to gravity. In other words, it "should" suffer the same fate other asset classes have -- mean reversion trade to a more natural price level.”

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Essentially, Garner’s watching the top edge of the upward trend line. Often, an inability to advance above this line prompts selling, causing a retreat to the lower end of the range. If multiple attempts at eclipsing 113.4 fail and the Dollar declines, it would be welcome news for investors.

The U.S. Dollar is inversely correlated to stocks. For example, there’s a negative 0.44 correlation of daily returns between the Dollar Index ETF  (UUP)  and the S&P 500 ETF SPY over the past 12 months. As a refresher, a -1 correlation indicates that the two move opposite each other, while a +1 correlation means they move in lockstep.

The Dollar also impacts earnings, which in turn, impacts stocks’ valuation. When the Dollar is strong versus foreign currencies, converting sales in those other currencies back into Dollars reduces the bottom line. Furthermore, foreign demand can shrink when the Dollar rises if buyers in those markets determine products or services have become too pricey.

This year, the Dollar hit 20-year highs relative to other currencies. Its strength has been a particularly painful drag on financial results, given about 40% of revenue in the S&P 500 components and 59% of technology sales happen outside the United States. As a result, corporate profit falls 0.5% for every 1% increase in the Dollar Index, according to Morgan Stanley.

In short, the “E” in price-to-earnings ratios has been shrinking, making stocks more expensive than they might otherwise appear. If the Dollar heads lower, corporate profit will improve, making P/E ratios more attractive.

Of course, there’s no telling if the Dollar will stall out, as Garner suggests. If it does move above her resistance line, she thinks it could head to its all-time high of 120. However, if it declines, then Garner writes, “the first bearish target would be about 105, but a round trip to 97 is possible with a much longer time frame.”

Treasuries Are The Alternative (T.A.T.A)

This year, a substantial increase to the Federal Funds rate has resulted in one-year and two-year Treasury note yields of 4.5% and 4.55%, respectively. Increasingly, that’s making them a competitive alternative to stocks, particularly among risk-averse investors like retirees.

As Doug Kass writes in his Real Money Pro diary today:

"The unprecedented instability of currencies and interest rates continues to underscore the likely end of the salad days of easy financial conditions and holds the key to the prospective course of global equity markets during the near term. Though I think we can move higher, elevated short-term interest rates remain a market hurdle and a restriction for meaningful gains from here...As mentioned, and for emphasis, all roads lead to interest rates. Goodbye TINA (There Is No Alternative), hello TATA (Treasuries Are the Alternative)."

The higher rates are also increasing interest expenses at companies with variable interest debt and, more broadly, slowing economic growth by making new projects more expensive. As a result, high yields are holding back corporate revenue and profit.

Importantly, because Treasury yields are the risk-free rate used in valuation models, they’re forcing a revaluation of future cash flows, causing downward pressure on equity valuations, particularly among money-losing businesses, like technology companies that are heavily dependent on future earnings.

The negative impacts associated with higher yields attracting money away from stocks while also taking a toll on corporate profit growth makes watching their direction from here important.

If yields decline, they’ll be less of a headwind to stocks, helping them move higher. But, unfortunately, there’s little reason to expect that yet.

In the short term, interest from new buyers chasing yield and deeply oversold conditions could mean that bond prices rally and yields retreat. However, a sustainable shift lower may require the Fed to stop boosting rates, something they’ve yet to signal. Currently, the CME FedWatch tool puts the odds of another 0.75% increase in both November and December at 98% and 75%, respectively.

Furthermore, the Fed continues to reduce the number of Treasuries on its balance sheet, creating another obstacle to lower rates. As of last week, the Federal Reserve owns $5.6 trillion in Treasuries, which remains significantly above the roughly $2.3 trillion owned at the end of 2019, before its COVID-era buying spree.

The Smart Play

We’re entering a more favorable period for stock market returns, but that doesn’t guarantee stocks will find their footing and head higher. A lot depends on if trends in the Dollar and Treasury yields cooperate, so keep a close eye on them.

If the Dollar and Treasury yields continue climbing, it’s likely to keep a lid on stock rallies. Conversely, if they fall, it could provide the support needed to create a durable recovery similar to this summer.

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