The “dollar smile” theory, which suggests that the value of the dollar typically appreciates during times of investor confidence or financial stress, is currently pointing towards a downturn for Wall Street. The recent surge in U.S. bond yields, coupled with concerns over global growth and investor sentiment, has led to a destabilizing effect on the dollar. The circumstances surrounding the dollar’s rapid rise since July are vastly different from the conditions that typically contribute to a strong dollar and buoyant Wall Street. As a result, there is a growing sense in the market that the negative relationship between U.S. stocks, the dollar, and yields could persist for the next three to six months. This risk-off environment has already led to a significant decline in returns and tighter financial conditions.
The dollar has experienced a 7% increase since mid-July, putting it on track for its 11th consecutive weekly gain, which would be a record winning streak since the era of free-floating currencies began. With U.S. bond yields still outpacing their global counterparts, the dollar’s appreciation may not be over yet. However, a stronger dollar and rising bond yields in a risk-off investment climate can unsettle Wall Street, potentially leading to a self-fulfilling spiral of selling and de-risking. While there are no signs of an impending crash in equities, the speed and extent of the dollar and Treasury moves, along with the tightening of financial conditions, warrant attention from investors.
The stronger dollar, along with skyrocketing bond yields and tightening financial conditions, can have significant implications for corporate earnings and future cash flows. The dollar’s surge can erode the value of U.S. firms’ overseas income, potentially impacting profitability. While it may be too early to see the direct impact on third-quarter results due to hedging by Wall Street firms, sustained strength in the dollar could affect fourth-quarter profits. Additionally, the surge in nominal and inflation-adjusted long-term bond yields poses a threat to future cash flows and profits, leading investors to exercise caution, especially in growth-sensitive and tech sectors that led the market rally earlier this year.