Will the market crash again? Watch the US dollar for clues

One of the biggest driving factors behind the market’s recent big sell-off was the bounce in the US dollar. John Stepek explains why the price of the dollar matters so much, and why investors should keep a keen eye on it.

We’ve discussed the mini-crash/rapid correction in the Nasdaq index quite a few times over the past week or so.

One thing we haven’t mentioned much though is the most obvious driving force behind the sell-off.

That is, the sudden rebound in the US dollar.

Why the price of the dollar matters so much

As I’ve mentioned before on many occasions, the cost of the US dollar is arguably the most important price in the world.

Dollars are involved in most cross-border transactions. Dollars are the closest thing to a universally accepted fiat currency that we have. The dollar is the global reserve currency. Almost everybody involved in any sort of trade needs access to dollars.

What’s the “price” of the US dollar? Well, it’s whatever it costs you to buy it when you don’t have any. So for a British person it would be the pound-dollar exchange rate, for example.

You can get an idea of how the dollar is trading against the other big currencies by looking at the DXY index. This looks at how expensive the dollar is relative to a basket of currencies of its biggest trading partners.

When the DXY goes down, the dollar is getting cheaper. When the DXY goes up, the dollar is getting more expensive.

If the dollar is getting cheaper, it means it’s easier to get hold of. In other words, a weaker dollar effectively acts as a stimulus for the entire world. If dollar policy is loose, then global monetary policy is loose.

This is only a slight simplification. You can already see that the Federal Reserve – America’s central bank – has embraced the role of global liquidity provider of last resort. That’s a role it started to realise it had during the 2008 financial crisis, and it’s one that it has unquestioningly accepted during Covid-19.

The Fed didn’t just make sure that money was cheap for Americans, it made sure that wobbly overseas markets could get hold of as many dollars as they needed too (via “swap lines”, which we won’t delve into right now).

Anyway, you hopefully get the point. All else being equal, when the dollar is expensive, it’s a sign that it’s getting harder for everyone around the world to get hold of money. In turn, that’s not great news for risk assets – tighter monetary policy usually makes stocks go down.

So how does this all relate to what’s going on right now?

How the stronger euro helped the Nasdaq’s stellar run higher in August

Earlier this year, the European Union managed to agree a deal on a joint Covid-19 recovery fund. That eased fears that the EU was heading for another big shouting match, and as a result, helped to boost the euro.

A rising euro will tend to mean a weaker dollar, as the euro is the second-most widely-used currency in the world (though second place is a very very long way behind first).

The euro really broke higher against the dollar from about mid-to-late July, which is when the deal was finally signed off after the usual late night marathon conferences. The euro then hit its most recent high at the end of August.

You may be interested to note that this same period from mid-to-late July to the end of August coincides with an absolutely hysterical run higher for the Nasdaq.

That all changed as September broke. Why? Well, at least one reason is because the European Central Bank (ECB) started to get twitchy about the exchange rate.

Here’s the problem: the world is locked in a currency war. It’s a quiet war. No one admits that it’s going on. But everyone wants a weaker currency because it helps to boost inflation (in theory at least). And Europe arguably needs it more than most because it’s good for exports from Germany, and helpful for tourism in the southern countries (not that there’s much of that right now unfortunately).

So while a rising euro would have been welcomed at first – it’s a nice vote of confidence – if it gets too strong too fast, that’s a different matter.

As a result, we started to get mutterings from various ECB members that while they don’t target the euro exchange rate, it did matter. Which is a nice way of saying – "actually, we kind of do target the euro exchange rate, and we’re looking at it right now".

In turn, that meant investors were edgy going into the ECB press conference yesterday. They wondered whether Christine Lagarde, current boss of the ECB, would take the chance to push the euro down, either by hinting at future action, or just “jawboning” – acting as if she was about to do something. That’s the sort of thing that Mario Draghi would have done.

But Lagarde was having none of it. If she’s bothered about the euro yet, she didn’t show it. And markets being markets, took the absence of a “no”, to mean “go ahead” – so they sent the euro higher. In turn, that weakened the dollar, and it helped to boost riskier assets (precious metals included).

Now that might not last. But the fact that the ECB team hasn’t yet decided to step in suggests there might be further for the euro to go. Capital Economics reckons there is scope for “modest further appreciation”.

There’s nothing particularly scientific about this. But as you may have gathered, markets themselves aren’t particularly scientific either. And it’s useful to have simple indicators to monitor – it helps you to feel on top of what’s going on, which does reduce the temptation to panic and over-react.

So keep an eye on the US dollar. If it turns up decisively, then that’s likely to be bad news for markets. But until then, it seems quite possible that the Nasdaq slide we just saw might be over for the time being. It might not leap right back up – and September is a sticky old month historically for markets – but I certainly wouldn’t assume that the only way is down.

For more on all of these topics, subscribe to MoneyWeek magazine – get your first six issues free here now.

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