MS Morgan Stanley

The powerful rallies that have lifted stocks, crude oil and emerging markets for the past three months have one important thing in common—the falling dollar—and investors are growing anxious that it could prove to be the weak link.

While the dollar is down 4.5% this year and near a one-year low against a basket of currencies, other investments have surged. U.S. crude prices are up 69% from their February lows. Gold was up 16.5% in the first quarter, its best in three decades. And emerging-market stocks, bonds and currencies have enjoyed double-digit gains in 2016.

Analysts at Morgan Stanley measured the correlation between a weak dollar and their own index of investor appetite for riskier assets. They found it near its highest level in 20 years.

The concern is that it is a relationship that could easily go in the opposite direction. The dollar is heavily dependent on perceptions of what the Federal Reserve will do with interest rates, and those perceptions could change quickly. Meanwhile, analysts warn that the fundamentals for oil, emerging-market assets and even many stocks look too weak to support the recent price gains on their own.

"Currency is the most influential factor for markets this year," said Graham Secker, head of European equity strategy at Morgan Stanley. "If the dollar starts moving higher, global risk appetite will fall."

On Friday, Labor Department figures showing that U.S. job growth slowed in April kept alive the bet on riskier markets. The data gave the Federal Reserve little reason to raise interest rates soon, economists said.

But traders fret that every new economic report could bring the Fed a step closer to raising rates—a move that would be expected to support to the dollar—if data come in stronger than expected. Higher rates make a currency more attractive to yield-seeking investors.

"I was like 'phew,' " said Paresh Upadhyaya, director of currency strategy at Pioneer Investments, after the weaker-than-expected jobs numbers were announced on Friday. "I breathed a sigh of relief that this risk rally will continue."

Mr. Upadhyaya, whose firm manages $249 billion, has shut down his bullish positions on the dollar in recent months in favor of emerging-market currencies, including the Indian rupee, Russian ruble and Argentine peso.

The rally's next test could come soon. This week brings retail-sales figures and speeches from Fed officials. The following week, the government announces industrial-production numbers.

When the dollar weakens, dollar-denominated commodities tend to appreciate in value, even though many of those markets are heavily oversupplied. Also, emerging-market currencies strengthen, and the foreign-currency debt of those countries becomes cheaper to pay back. Still, many developing economies are struggling with waning demand from China, a major commodity customer. Stocks and other assets could also get caught in any dollar updraft.

Morgan Stanley's Global Risk Demand Index, which measures risk appetite by analyzing moves in markets such as stocks, commodities, and emerging markets, is moving nearly in the opposite direction of dollar strength. The correlation reached negative 86% in early April.

A large negative correlation means risky assets tend to fall when the dollar gains and rise when the dollar falls. As of May 5, the correlation was minus-76%.

The Fed began the year with plans to raise interest rates four times after boosting rates by a quarter of a percentage point in December. But in March, Fed Chairwoman Janet Yellen signaled that the central bank was in no hurry to raise interest rates, citing slower global growth.

Federal-funds futures, used by investors and traders to place bets on central-bank policy, showed Friday that the odds for a rate increase at the Fed's June meeting were 13%, while the chances of a rate increase at the December meeting were 61%, according to CME Group.

Hedge funds and other speculative investors are now more bearish on the dollar than at any other time since February 2013, data from the CFTC and Scotiabank shows.

The negative view on the dollar has grown as the Fed displayed a more cautious view on raising interest rates, while central banks in Europe and Japan appear reluctant to ease their own monetary policies further. That is bad news for the dollar, which has benefited from expectations that the gap between U.S. and foreign interest rates will continue to widen.

However, that bearish positioning also means any sign the Fed is turning more hawkish could send investors scampering to buy dollars, pushing the U.S. currency sharply higher.

"The market has become complacent," said Steven Englander, head of G-10 FX strategy at Citigroup Inc. "There's the risk…the Fed gives a sudden indication that really surprises the market."

Indeed, some analysts warn that investors may be underestimating the chance of an earlier rate increase. A number of Fed officials have suggested that a move toward higher rates isn't off the table in the near term. Dallas Fed President Robert Kaplan said he would support a move in June or July if economic data improve. Fed officials in St. Louis and Atlanta have expressed similar thoughts.

A strong dollar doesn't necessarily spell bad news for all markets. Stock markets in Japan and Europe have suffered this year, in part because of their currencies appreciating against the dollar. That weighs on local exporters.

"I don't think necessarily a rising dollar is negative for all asset classes," said Peter Fitzgerald, head of multi assets at Aviva Investors. "A rising dollar would see the yen and the euro weakening, which would be supportive for those markets."

Write to Ira Iosebashvili at ira.iosebashvili@wsj.com, Chelsey Dulaney at Chelsey.Dulaney@wsj.com and Christopher Whittall at christopher.whittall@wsj.com

(END) Dow Jones Newswires

May 09, 2016 19:25 ET (23:25 GMT)

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