Stronger US Dollar May End Reflation Transactions

This article was written exclusively for Investing.com.

Reflation transactions were quite intense, with interest rates rising. However, it is on the rise, with restrictions reappearing in some parts of Europe and excessively loose monetary policies implemented by central banks worldwide. This will likely end reflation and commodity-based trading in the stock market.

The declines have already started; and there was a decline in prices. This led to an exit from energy and materials. At the same time, a decline in multinational stocks and emerging markets is likely. Even the financial sector can get caught in this wave, because banking stocks have gone up very sharply.

US Dollar Index Daily Chart

US Dollar Index Daily Chart

The Rise of the Dollar

The rise in the dollar came with the jump in bond interest rates, with the shaping of a better growth outlook in the US in recent weeks, even as some parts of Europe continue to struggle to overcome the coronavirus epidemic. Thus, commodity prices, which were negatively affected by the strengthening of the dollar and concerns that a weaker growth would hurt demand, also took a serious hit.

This weakness has also impacted reflation operations, and sectors such as Energy, Industry and Materials suffered weakness this week. If the dollar continues to strengthen and concerns about global growth persist, it could signal the end of reflation.

Additionally, emerging markets suffered during the last trading sessions due to the strengthening of the dollar. If the USD remains strong, it could put funds such as the iShares MSCI Emerging Markets ETF (NYSE 🙂 into decline, possibly putting even greater pressure. A bearish pattern is forming in the EEM, potentially known as a head and shoulders pattern. The fund needs to go below $ 51.50 to confirm this negative trend, which points to lower prices ahead.

EEM Daily Chart

Banks May Also Be Affected

Bank shares were also under pressure, despite the stabilization of bond yields at high levels and widening of the gaps. The group has recently made a splash and has exceeded reasonable levels, at least in the short term.

Just last week, the Financial Select Sector SPDR® Fund (NYSE 🙂 ETF saw an increase in put options of $ 33 for April 16, due. The number of open positions has increased by about 25,000 contracts, and data show that put options were bought at around $ 0.60 per contract. This means that the XLF could drop to about $ 32.40 by mid-April.

Shares such as Goldman Sachs (NYSE 🙂 and Morgan Stanley (NYSE 🙂 have risen in an almost straight line since October 30th. Both stocks are in a significant uptrend that could lead to a serious drop if broken. Additionally, the RSI of the two stocks is also diverging with the downtrend, indicating that the stock momentum is reversing.

Goldman Sachs Daily Chart

Goldman Sachs Daily Chart

Reflation Processes Done?

If the dollar continues to strengthen, it will create ripple effects in different parts of the stock market, further weakening reflation transactions. Add to this the rising interest rates, which negatively affect the technology industry, and the stock market may face a serious problem.

If interest rates begin to fall and the dollar weakens, it will allow reflation to continue, pushing shares in these sectors even higher. However, if there is no reversal in the dollar or interest rates, the reflation process may come to an end. This would be very bad news for the rest of the stock market.

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