The world is waiting for the Fed to stop.

The Fed has raised interest rates aggressively, causing the Dow Jones, S & P 500 and NASDAQ to withdraw 15.01%, 15.68% and 17.84% from their periodic highs on Aug. 16, respectively. Capital markets in other regions are also wailing.

After it was announced on September 21, 2022 that it would raise interest rates for the third time this year by 75 basis points, raising the target interest rate range to 3% Murray 3.25%, the Fed does not seem to have any plans to stop. The central bank has already raised interest rates by 3 percentage points this year and is expected to raise interest rates by 2023. The target interest rate may reach 4.6%, meaning there is still 1.35% room to raise interest rates.

At the same time, the Fed is also actively shrinking its balance sheet, absorbing dollars, the dollar exchange rate has soared, and the dollar index has reached a 20-year high, see chart below.

Since the beginning of this year, the dollar index has risen 19.73%, corresponding to a decline in the exchange rate of other major currencies.

The dollar index measures the performance of the dollar against a basket of major currencies, with the euro accounting for the largest share of the index, accounting for 57.6%, followed by the Japanese yen (13.6%), the pound (11.9%), the Canadian dollar (9.1%) and the Swiss franc (4.2%).

As can be seen from the table below, the euro has fallen 15.75% against the dollar so far this year, while the pound and yen have fallen more than 20% against the dollar.

What is the reason behind the rising exchange rate of the US dollar?

A strong dollar does not happen overnight, but it is not unpredictable.

As early as when the Federal Reserve released water in 2020, it could be predicted that when flood irrigation ushered in a rare bull market, it would inevitably face the embarrassment of a bear market when it was harvested in the future.

The direct reason for the Fed to raise interest rates is to suppress inflation. Where does inflation come from? It is precisely the impetus brought about by the measures to stimulate the economy by releasing water in 2020. As the economy has gone up, consumer spending has increased sharply, coupled with problems such as the breakdown of the global supply chain, supply continues to fall short of demand, and inflation follows.

At present, the Federal Reserve dares to raise interest rates substantially because the current employment situation in the United States is very ideal, the unemployment rate is low, new jobs continue to rise, and employment participation remains strong, which provides the strength for the Federal Reserve to raise interest rates. it also provides a relatively good reason for global capital inflows to the United States.

See the chart below, comparing the long-term comprehensive yield of the US Treasury with the long-term real rate of return (inflation-adjusted real rate of return), we can find that market expectations for inflation have stabilized recently, and see the black curve flattening below, which means that the market still has confidence in the effectiveness of the Fed in suppressing inflation.

Excluding inflation, real yields are on an upward trend, and the curve has recently become steeper, reflecting rising expectations of higher interest rates.

The US dollar is already the main settlement currency for international trade and the most important reserve currency for all countries. the United States still has strong economic growth, rising interest rates and expectations of raising interest rates, which have further increased the attractiveness of the dollar as a safe haven for international funds. The Fed's shrinking schedule has also technically boosted the flow of the dollar, all of which are the reasons for the recent rise in the exchange rate of the dollar.

If the dollar is strong, why should the money abandon US stocks?

This is because the Fed's release of water in early 2020 has led US stocks to the peak of the bull market in 2021.After turning to collecting water, the opportunity cost of capital increases, do not dare to be sentimentally attached to the equity investment whose valuation is already high, and flee one after another.

On the other handRaising interest rates may affect consumers' consumption expectationsTo take a simple example, the increase in interest on credit cards will naturally reduce the desire of price-sensitive consumers to spend.

In additionThe high exchange rate of the US dollar also affects the future performance of US stock listed companies.With the highest market capitalization$Apple (AAPL.US)$As an example.

Of Apple Inc's quarterly income in June, Europe, Greater China, Japan and other Asia-Pacific regions together accounted for 54.83% of his total income. The currencies of these regions are weak against the US dollar, which is not conducive to the pricing of their products. And when the income from these regions is converted into US dollars, it will result in exchange losses because of the exchange depreciation during the period.

Apple Inc said that the impact of the strength of the dollar on its quarterly revenue growth in June was about 300bp (1.87 per cent in the Apple period), and its chief financial officer predicted at the results conference. Apple Inc's quarterly income growth in September will be negatively affected by 600bp because of the strong dollar.

Apple Inc is not a special case.$Microsoft (MSFT.US)$、$Tesla (TSLA.US)$、$Coca-Cola (KO.US)$The products of a number of American companies, such as those sold mainly to overseas markets, are also negatively affected by the strength of the US dollar, and will continue to be reflected in their results in the second half of the year and even next year, offsetting their potential growth to some extent and undermining market optimism about their performance.

This is the internal reason for the decline in the performance of US stocks.

Is the strong dollar running out of steam?

Given that inflation is still extremely high, the Fed's interest rate hike cycle is not over, the contraction is continuing, and there is still some support for the dollar.

However, it should be noted that the world's major commodities are still priced and settled in dollars, and a strong dollar may make these commodities more expensive, coupled with the co-effect of interest rate hikes in many countries. more or less reduce the willingness of companies to expand and invest and consumers' desire to spend, further slowing global economic growth.

As demand falls, commodity pricing pressure and the resulting inflationary pressure may be buffered. Once inflation improves, or the risk of stagflation decreases, market expectations for interest rate hikes cool, which may divert the US exchange rate, which has accumulated some upward trend.

On the other hand, the normalization of energy prices in Europe and the demand growth brought about by the return of the Chinese economy may be the driving force of the global economic recovery, and the stronger exchange rates of these more dynamic regional currencies will weaken the exchange rate of the US dollar.

Therefore, in the short term, the strong US dollar may accumulate a certain amount of adjustment potential because it is moving too fast. In the long run, as the fundamentals of the world economy improve and other currencies become more attractive, the US dollar may not be able to stay high for too long.

The performance of the stock market is the same. When high-quality equity assets show price attraction because of the wave of investment, they will naturally attract discerning and smart money, coupled with the boost of economic normalcy is expected to correct future valuations.

The current sharp fall in the stock market may be providing an opportunity to absorb while it is low.