Why only a stock market crash would stop the dollar's surge, contrary to normal behavior

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  • The dollar is soaring in a belated bond-market response to the Fed’s taper announcement. 
  • Only a sustained stock market fall could change the central bank’s stance. 
  • Evergrande has proved a distraction, other crises may subside as well.

Big things move slowly – bond markets have finally reacted to the Federal Reserve’s decision to taper purchases and have finally suffered a sell-off. In turn, that has made the dollar more attractive, sending EUR/USD and GBP/USD to multi-month lows. What is next?

The logic is simple – the Fed is set to announce the reduction of bond-buying next month, and with prospects of less demand from the Fed, investors are selling off Treasuries. Greenback gains accelerated when 10-year yields jumped to around 1.50%. 

Crises come, crises go

But, the dollar rises also on safe-haven flows, and there is trouble brewing in the world. China is suffering from power outages that have already disrupted industrial output in the northeast. US Treasury Secretary Janet Yellen said that America would default on its debt if Congress does not lift the debt ceiling by October 18.

However, there is another crisis that trapped markets last week and is half-forgotten – Evergrande. China’s second-largest property developer owes some $300 billion and has already missed some interest payments to bondholders. Moreover, Beijing vowed to refrain from bailing it out. Nevertheless, authorities are unlikely to let the issue snowball and bury the economy under an avalanche. By injecting liquidity and helping banks, the situation has stabilized. 

The damage is contained and markets have moved on – the same is set to happen with other crises. Delays in shipments and supply-chain issues are set to persist and the world will cope. America always pays its dues and politicians only act when push comes to shove. 

All in all, the dollar’s move mostly depends on the Fed.

Stocks lead the Fed and the dollar

What could move the world’s most powerful central bank? Wall Street. Fed Chair Jerome Powell and his colleagues cite “financial conditions” as one of the things they care about, even if falls beyond their employment and inflation mandates.

When the Fed raised rates for the fourth consecutive time in late 2018, markets underwent a suffer-fest instead of celebrating a “Santa Rally.” Soon after New Year’s, the bank signaled a change in policy and later cut rates. Will history repeat itself? 

A one-day 2% fall in stocks is insufficient to derail the bank – especially as dip buyers are aplenty. However, a fall of more than 10% from the highs – and something nearing an outright 20% bear market – is already a new kettle of fish. 

Overall, a substantial drop in stocks could result in the Fed delaying its tapering – and the prospects of more dollar printing would hurt the currency. That counters the safe-haven dollar concept, but correlations are there to be broken. 

Wednesday’s moves are telling. At the time of writing, the S&P 500 is up some 0.45% while the dollar is on a relentless rise, sending EUR/USD closer to 1.16 and GBP/USD to see 1.34 on the horizon.