There has been an unprecedented rally going on in an often-ignored corner of the market. And its enormous move has important ramifications for U.S. equities. 

Starting in June, the U.S. dollar index, a measure of the value of the dollar relative to a basket of international currencies heavily weighted to the euro, has rallied 25%.

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The current rally is even greater in both speed and magnitude than the one we saw during the 2008 financial crash.

This is a historically significant move. The index just made a key upside break above three decades’ worth of resistance, shown on the monthly chart below.

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Before we get into what this means for your portfolio going forward, let’s start with a quick primer on currency. 

Currency is always valued relative to other currencies. For example, we can value the U.S. dollar based on how many Japanese yen one dollar can purchase. The dollar is often valued against the euro or a basket of currencies, which is what the dollar index above measures.

Currencies have two main factors that drive their trends. The primary factor is the interest rate differentials between two countries. The country with the higher interest rate tends to see a stronger currency because investors seek the higher rate of interest. In seeking that higher rate of return, investors sell the currency of the country with the lower interest rate and buy the currency with the higher interest rate. Then, they invest the foreign exchange in the financial instruments offering better returns.

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Generally, economic policies that raise interest rates, end/reduce quantitative easing (QE) programs or cause a sovereign budget surplus support a stronger currency value. By contrast, economic policies that lower interest rates or implement/increase quantitative easing programs tend to cause the currency to weaken.

The second major driver of currency trends is geopolitical in nature. Instability in a country — be it political, economic or military — tends to depress a currency and cause it to fall. Investors find these conditions unpalatable and sell out of the currency to secure their money in a safer one. Geopolitical revulsion of a currency by investors is one cause of hyperinflation, i.e., when prices for goods soar out of control.

For a long period of time, the market has considered the U.S. dollar as the ultimate “safe haven” currency given U.S. military dominance and economic power.

So why is the dollar soaring now?

Two central bank forces occurring simultaneously are causing a turbocharged rally.

As many of you already know, the Federal Reserve’s six-year quantitative easing plan finally came to an end last fall. This was a de-facto tightening of economic policy, which was bullish for the dollar. Additionally, Fed fund futures show a 50% chance that the Fed will raise rates as early as next month given the general improvement in the economy.

Meanwhile, European economic weakness, along with geopolitical concerns surrounding the potential chaos from a Greek euro zone exit, has caused the European Central Bank (ECB) to cut interest rates and launch its own version of QE. This loosening of economic policy is bearish for the euro but bullish for the dollar, which looks stronger in comparison.

The ECB’s euro-debasing measures really lit a fire under the dollar and are having an impact on stocks here at home.

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Mid- and small-cap stocks generally have very little foreign currency exposure compared to large-cap international conglomerates. A rising dollar makes the latter’s products and services more expensive, which bites into revenue and earnings. Mid- and small-cap stocks have benefitted from this trend at the expense of large-cap stocks. 

One way to view this trend is with a ratio or spread chart that divides the Russell 2000 by the S&P 500. When the line is moving up, small caps are outperforming the broader market. Currently, we’re seeing small caps break out of an eight-month sideways trend.

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Anecdotally, I’ve noticed many more small- and mid-cap stocks appearing in the quantitative screening tools I use to select stock picks for my Alpha Trader subscribers. 

We have participated in this small- and mid-cap outperformance over the past several months. Recent winners include Huntington Ingalls Industries (NYSE: HII), up 28% in four months, Centene (NYSE: CNC), up 88% in seven months, and Ulta Salon, Cosmetics & Fragrance (NASDAQ: ULTA), up 13% in less than two months.

And last week, I added three new small-cap positions to the Alpha Trader portfolio.

One is a food distributor and grocer with a market cap of $ 1.2 billion and a dividend yield of 1.8%. Shares have soared 6.8% in less than a week since my system signaled this stock was a “buy.”

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Another is a $ 2.4 billion generic drug company that is posting triple-digit revenue and earnings growth. Shares have rallied 2.9% in the three days we’ve held the position.

And, finally, my system alerted me to an $ 800 million media company poised for a major breakout. Since then, the stock has already jumped 6.4%. 

The huge moves in these stocks speak to the outperformance of small caps in the current market, but it is also a great example of how the Alpha Trader system spots stocks right before they make huge moves.

What do I see on the horizon? I think the dollar index will consolidate its huge gains over the next few months. The price reversal that occurred following the March Federal Open Market Committee (FOMC) meeting suggests the short-term trend is tired. I believe the odds favor a trading range between 94 and 101.

Despite a potential pause in the dollar’s uptrend, I expect small- and mid-cap stocks to continue showing better relative performance than large caps. 

If you want to learn more about how the Alpha Trader system pinpoints some of the fastest-moving small and mid caps, you can click here.

This article was originally published on Dollar’s Unprecedented Rally Could Light a Fire Under These Stocks

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