The Dollar, Interest Rates, and Stocks | IJS Speaks

The dollar has taken investors on a wild ride since the onset of the COVID-19 pandemic lockdowns in March 2020 when the index peaked around 103, to now where the index is trading around 104. The road from then to now, however, saw a near 30% rally from the lows of early 2021 to the highs of fall 2022. While all of 2023 and so far into 2024 the index has been confined to a narrow range, with one notable attempt to break-out last fall. The reasoning behind the movements in the dollar has evolved with the economic cycle, or at least where market participants perceive the economy to be on the economic cycle.

Interest rates, proxied by the US 10-year treasury for simplicity, have sustained a clearer trend than the one seen in the dollar. From the start of the pandemic to now interest rates have moved in one general direction, and that is up. We’ve seen three periods of consolidation so far where some investors began speculating that rates were peaking, just to see a further sell-off in bonds and interest rates drift higher. Much of 2022 was spent with stocks and bonds moving in the same direction, as the Fed commenced its monetary policy tightening cycle. The longstanding 60/40 portfolio model broke down, and the yield curve began to flatten and eventually invert.

Stocks, proxied by the S&P500 for simplicity, also sustained a clearer trend than the one seen in the dollar, with just two notable periods of retracement, which have both since been surpassed. Spring of 2020 at the onset of the pandemic, which was surpassed that summer, and most of 2022 while the Fed was well into its rate hiking cycle, which was eventually surpassed last month (January 2024). From a technical standpoint, stocks are breaking out of a continuation pattern, meaning that the market is attempting to do more of what it’s been doing. Now that we have an idea of where the price of stocks in general might be headed, let’s come up with a narrative keeping in mind that the simpler the better.

The lions share of US stock market returns where generated by 5 to 7 tech companies in the last couple of years, both on the way up and on the way down. They dragged down the market when the Fed was raising interest rates because their future cashflows were more heavily discounted as well as some of their dependency on capital markets. Then with the introduction of Artificial Intelligence (AI) software and its rapid proliferation, the tech companies at the forefront of this technological rollout are once again dragging markets higher. There are suddenly innumerable opportunities for subtle increases in productivity across the US economy and eventually the rest of the world, which suggests that businesses large, medium, and small can be efficient and profitable even with higher costs of capital are represented by general interest rate levels.

The forecast for interest rates has been a hotly contested topic since we started experiencing rapidly rising inflation around the globe because of the COVID related supply chain and labor market disruptions. The direction has been clear (higher rates), but the destination (what level), and duration (how long) has always been contended. My interpretation of the inverted yield curve is not necessarily forecasting an economic recession, but more so a financial market recession, which we have already experienced and are well on the way to recovery and by some estimations a new expansion. A normalizing of the yield curve signals a positive term structure and a growing economy, or at minimum expanding markets for risk assets like stocks and real estate.

Considering where unemployment levels currently are in the US, as well as the restructuring that is underway with global supply chains there is enough structural pressure to keep inflation hovering about the Fed’s target to stay the committee’s hand on cutting rates too much or too quickly. But if we are to expect...