What Does The Rising Dollar Means To The Economy And To Investors?

Earlier this week, we saw a spike in the US dollar. After months of being stuck in a sideways trading pattern, the US dollar ($USD) is starting to aggressively move upward:

Why is the US dollar suddenly rising?

Global investors are starting to allocate to dollars. While the US has its own problems, the dollar is still the strongest currency in the world and is viewed by many as a safe haven.

Last week, Moody's downgraded the UK credit rating as the credit ratings agency is worried that growth will remain sluggish in the UK for the next few years. Anticipation of the downgrade has already caused the British Pound ($XBP) to drop vs the US dollar.

In addition, many foreign investors are viewing the upcoming sequestration in the US as a positive since it is a form of debt reduction.

What does a rising dollar mean for the stock market?

Since the 2008 market collapse, the US dollar and US stocks have shared a negative correlation. In other words, stocks have risen whenever the US dollar has dropped.

This negative correlation is mostly related to the way corporate earnings from overseas are booked.

As the majority of Fortune 500 companies derive up to two-thirds of their profits from overseas, a strong US dollar is not something US investors should cheer for.

US goods are less competitive overseas since a strong dollar means foreigners can buy fewer US goods with their own currency. In turn, a strong dollar also makes foreign imports more competitive here in the US.

The rising dollar may already be having an impact on corporate earnings, as earnings are starting to weaken:

During the current cycle (since 2000) as the US dollar has fallen, imports and exports have been significantly impacted from just a 10 percent drop in the dollar's value. It is safe to assume the reverse will hold true if we enter an extended period of strengthening in the dollar:

 Source: Center for Economic Policy and Research, Bureau of Economic Affairs

Strong Dollar = Good News At The Pump

Historically, the energy sector performs strongly this time of year. While oil (OIL) has risen lately (resulting in higher gas prices), a stronger dollar will begin to help consumers at the pump. When the dollar weakens, foreign oil companies ask for higher prices in dollars because they need to offset the weaker dollar so that they can make the same money in their own currency.

If the dollar continues to strengthen, this correlation will cause oil prices to drop -- leading to some stabilization of gas prices:

Should the Fed Intervene? 

The Fed actually has numerous tools it can use to combat a rising dollar, however they may not want to.

The US is still a consumer-based economy, and rising fuel prices means less money consumers can spend elsewhere. Consumers already need a break, due to the uncertainty of the upcoming sequester's impact and rising payroll taxes.

Consumer spending has been slowing since 2011. A drop in gas prices may help reverse that trend:

For the Fed, this will be a tightrope walk: Let the dollar strengthen enough to help lower gas prices, but not too much to cause foreign products to become more competitive and hurt US-based manufacturing.