Here's why the stock market loves a weaker dollar – MarketWatch

The U.S. dollar’s 2017 decline despite positive economic growth and tightening monetary policy has puzzled some market participants, but it makes sense and should be taken as a positive for markets, according to Neil Dutta, head of economics at Renaissance Macro Research.

In foreign exchange markets, gains and losses are a zero-sum game—a currency can appreciate or depreciate only against another currency. So far this year, the weakness in the dollar was widespread, however—the buck is down against most rivals, including some in the emerging markets.

The ICE Dollar Index DXY, +0.03% which tracks the buck against half a dozen major rivals is down 10% year to date, recently trading at 91.896.

The euro EURUSD, +0.1088%  was trading at $1.196 on Tuesday and had appreciated nearly 14% year to date. The dollar weakened against both its neighbors: The Canadian dollar USDCAD, +0.5946%  is up 9.5%, while the Mexican peso USDMXN, +0.3565% which was beaten down in 2016, is up 14.5%.

Read: The stock market’s wall of worry is absolutely flattening the U.S. dollar

What is driving the weakness in the dollar? Dutta, in a note, said that it has more to do with the rest of the world than what’s happening domestically.

“Stronger global growth is clearly an important factor,” said Dutta.

He looked at changes in growth expectations in relations to changes in currencies and found a compelling relationship: stronger-than-expected economic growth corresponded with better performance against the dollar.

In a chart below Dutta described how the U.S. dollar has tended to depreciate more against those countries that have seen larger upward revisions to 2017 GDP estimates.

“With U.S. growth climbing 3% [annualized] in the second quarter and tracking near 3% in the third quarter, the dollar decline is not really about weak growth domestically. Rather, the decline is a function a stronger growth overseas,” Dutta said.

Dutta draws three conclusions from this observation:

—With the dollar weakening and global growth solid, it is not hard to make the case for a narrower trade deficit, which means that a drag from widening trade deficit is less likely.

—A weaker dollar will tend to lift corporate profits, especially for those firms with a high share of foreign sales, which means U.S. stocks could continue to be supported by positive earnings outlooks.

—A weaker dollar will support core consumer price inflation, he said, noting higher inflation tends to ease financial conditions by lowering real interest rates.

Easier financial conditions, often a product of weaker dollar, in this case, were driven by stronger growth abroad, rather than stronger growth in the U.S. and may muddy waters for the Federal Reserve, however.

“The easing of financial conditions is not necessarily a reason to speed up, but it’s harder to see why the Fed should be signaling an even slower approach right now,” Dutta said.

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