Weekly Market Perspectives: Policy divergence pushes dollar higher, correlation lower
Published: September 11, 2023
US economic data continues to trend in a positive direction with recent industrial production, manufacturing demand, wholesale inventories, and labor market sentiment pointing to healthy economic activity. Several Federal Reserve Open Market Committee (FOMC) members suggested that more rates hikes may be necessary if the strength continues. The market is expecting rates to be held at the current level at the next FOMC meeting (Sept 20th), but the probability of a rate hike at the November 1st meeting has risen amid robust activity, sticky prices (core CPI), and a solid labor market. Rising yields, particularly on the short and middle part of the curve, pushed the market lower last week – the S&P 500 fell -1.3% and the US Aggregate bond index traded lower by -0.3%.
One of the big stories of the week has been the recent strength in the US dollar. Current US policy rates along with the strength and resilience of the US economy in a world of poor economic growth has fueled a rally in the US currency for the past eight weeks – the longest run since 2005. The advance pushed the relative strength indicator to overbought levels but there are other technical and fundamental factors that should support current levels in the near-term. While the US dollar remains below the highs of the 2022, the rapid rise and renewed strength has prompted foreign central banks to respond with control measures to stabilize their own currency. Japan issued strong warnings to quash market speculation, China reiterated their currency control stance shortly after, and several European Central Bank Governors advocated for increasing policy rates sooner rather than later to combat the greenback’s strength. So far, these measures have only been verbal indications, but it is clear policymakers intend to avoid letting their currencies fall too far in relation to the dollar. Since mid-July, the Japanese Yen has fallen -6.6%, the Chinese Renminbi has traded lower by -2.6%, and the Euro is down -4.7% relative to the US dollar.
With the Federal Reserve nearing the end of the current rate hike cycle and aiming to keep rates steady for the foreseeable future, reduced rate volatility should help correlations between asset classes and among individual securities diverge. Historically, meaningful policy changes from fiscal and/or monetary authorities result in risk assets generally moving up or down in tandem. Since the start of the Fed rate hike cycle in early 2022, correlations between stocks and bonds have been increasing, offering fewer diversification benefits to investors. As policy levels off and investors return their focus to fundamentals and future growth prospects, stocks and bond returns tend to diverge which offers greater diversification within a portfolio. According to research by Bloomberg and Columbia, correlations between stocks and bonds are expected to turn negative by the end of the 2023.
Reading correlation on a shorter time horizon, investors are already seeing a divergence among S&P 500 stocks and equity markets more broadly. Since the start of 2023, the average stock correlation to the S&P 500 has been trending lower with the reading now well below 0.4 – a signal that individual stock return is becoming nearly uncorrelated with the broader market. Business fundamentals, not inflation or interest rates, have been a greater focus in the second half of 2023 and should continue to be a focus as macro policy normalizes. Whether this ends up being a positive development for active stock pickers is yet to be determined, but this should benefit investors with diversified equity portfolios.
Source: Bloomberg, Columbia, YCharts