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Why the surging dollar and Treasury yields are weighing on stocks

This is The Takeaway from today's Morning Brief, which you can sign up to receive in your inbox every morning along with:

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The US dollar index (DX-Y.NYB) rallied to the highest level since November on Tuesday, as the US 10-Year Treasury Note yield (^TNX) also hit the highest level since 2007.

Stocks tumbled, sending the Nasdaq Composite (^IXIC) down 1.6%, or about 9% from its July high. The S&P 500 (^GSPC) followed suit, finishing the day 1.5% down.

Meanwhile, the CBOE Volatility Index (^VIX), known as the "fear gauge," settled at the highest level since May and the Ice BofA MOVE Index (^MOVE) jumped — all signaling risk aversion.

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It was all because of the Fed. While bullish trends in the dollar and government bond yields have been underway for months, last week's release and press conference accelerated the rally in rates to new multi-year highs. Investors were caught flat-footed once again and forced to price in even higher rates for even longer.

Higher sovereign yields and lower bond prices attract fresh investors to the US from abroad, who must first buy dollars to buy said bonds — amounting to a virtuous cycle of higher rates and a stronger dollar.

Unfortunately, the speed of the moves in the highly leveraged world of bonds and currencies is upsetting the substantial inertia in global markets — all of which weighs on risk markets like stocks.

The US dollar index is set to close its 11th week of back-to-back gains. And barring an unusual and substantial pullback, the dollar will become technically overbought on the Relative Strength Index this week — the first such signal in nearly a year.

Meanwhile, the 10-year yield is also about to notch its own overbought signal on the weekly time frame — also a first in nearly a year. In fact, the rally in US stocks that began last October came as both the dollar and 10-year worked off their overbought status by moving sideways-to-down for a spell.

Overbought dollars and yields — and especially surges in both — are correlated to tough times for stocks.

The chart above shows that the last time yields and dollars were overbought coincided with 2022's bear market, and that these challenges are rearing their head again as the lone purple dot signals. Often, but not always, turbulence in the market has coincided with these overbought signals.

If those current moves are done, stocks may have already paid enough of a price to continue their ascent after this "healthy" pullback. But history suggest we are at least a few weeks away from that point.

All of this should give hope to stock bulls that once the current repricing turmoil in bonds and currencies is done, stocks can find their footing again. Eventually, rates and the dollar will settle into a new equilibrium, and risk markets can resume being a bit riskier (i.e. higher stock prices).

Until then, stocks may be in for another patch of rough air.

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