Will The S&P 500 Extend Its Record Rally Against Rising Yields And USD?

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  • US stocks returned to ‘rally mode’ amid strong earnings, vaccine rollout and fiscal stimulus hopes
  • A strengthening US Dollar and rising Treasury yields may hinder the rally however
  • The S&P 500 index is trading at a 31.6 price-to-earnings (P/E) ratio, far above its 5-year average

Global stocks are back to ‘risk on’ mode after a brief pullback seen in the end of January. Investor confidence appeared to be revitalized by strong Q4 corporate earnings and guidance, falling Covid-19 cases and hopes that Democrats can push through a large fiscal stimulus package soon. Renewed reflation hopes – expectations that demand and output will pick up with fiscal spending – have also led the US Dollar to strengthen alongside rising longer-dated Treasury yields, which may hinder stock markets’ rally.

The DXY US Dollar index and the S&P 500 index exhibit a historic negative relationship, with the past 12-month correlation coefficient standing at -0.892. This suggests that further strengthening in the Greenback may exert pressure on the S&P 500 index, as more than 40% of the index constituents’ revenue comes from overseas. A stronger US Dollar simply translates into lower overseas sales due to foreign exchange differences. For emerging markets, a stronger USD may also discourage capital inflow and weigh on equity performance.

S&P 500 vs. Dollar Index Chart

Source: Bloomberg, DailyFX

Longer-dated US Treasury yields are climbing, leading the yield curve to steepen further. Rising Treasury yields make stocks less appealing as compared to government bonds, as the later seem to be offering better reward-to-risk ratio now.

1-Week Changes in US Treasury Yields

Source: Bloomberg, DailyFX

Nonetheless, an improved fundamental picture and robust Q4 corporate earnings may continue to buoy equity prices. The job market showed signs of improving, with the vaccine rollout helping to bring down daily Covid-19 infections rapidly in the past few weeks. The ADP private payrolls number and weekly unemployment claims figure both beat market expectations last week. The Fed’s commitment to a dovish stance at the January FOMC meeting alongside a similar tone from the RBA and BoE points to an extension of the current accommodative monetary environment. Against this backdrop, investors may be incentivized to park their money in riskier assets looking for yield and growth.

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