Dollar Weakness and Stock Market Strength -- the Data

Anyone who is following the market on a daily basis is paying attention to the strength of the dollar versus other currencies.  It can be confusing.  While a strong dollar might seem like a good thing, there is actually an inverse market relationship with stocks -- at least in recent times.

I described the basics of the dollar debate here:  Understanding the Debate on the Dollar.  There are many opinions -- prescriptive, political, and descriptive.  The next step is to consider some data.

Dollar Strength and U.S. Equity Market Returns

In my last article I highlighted the inverse relationship between a strong dollar and the stock market.  This chart provides a dramatic illustration of the relationship for calendar 2009.

 
Sometimes a chart tells the story in a glance, but I always like to look at data as well.  I used the Fed's measure of the dollar versus a broad basket of currencies, weighted by trade.  The series started in 1995.

The correlation for this year is an almost perfect negative relationship:   -.96.

A negative relationship sometimes stands out even more if you invert one of the scales.  Here is that chart.

The data are the same, but the tight relationship is especially clear using the inverted scale.

So much for what we know.  An obvious question for investors in stocks is what would happen if the dollar gets stronger.  Perhaps we should look at more data.

A Longer Perspective

Some believe that a strong dollar is consistent with economic growth and a strong stock market.  To examine this concept, we need to consider more data.

If we look at the full data series, we see long periods where dollar strength was consistent with a rising stock market.  In fact, the correlation between the two series is a positive value:  .35.

For an objective analyst of data, the chart suggests three conclusions:

1. The relationship changes over time;
2. The last year is quite atypical;
3. There are other important variables at work.

The Carry Trade

The prevailing hypothesis about the dollar/stock relationship is the "carry trade."  Supposedly there are investors/companies/speculators who are able to borrow in dollars at a very low interest rate.  This makes the dollar the "funding currency."  Most outspoken on this subject is Nouriel Roubini, who sees disaster ahead.  [Full disclosure -- I am a contributor at Nouriel's valuable site.  I respect and appreciate his encouragement of alternative viewpoints.]

The borrowers do not then do the obvious -- lend in another currency, hedging the difference with a forex trade.  Instead they supposedly use the borrowed funds to engage in a variety of speculative trades -- emerging markets, real estate, and, of course, US stocks.

Following this logic, there is now a speculative bubble of major proportions.  This seems implausible.

My skepticism comes partly from the lack of any real data supporting this viewpoint, and partly from the daily trading.  If you really had this trade on, would you really take it off if the dollar moved by 0.4%?  The carry trade hypothesis does not explain the closely calibrated trade between the dollar and stocks, but we see this every day.

For now, let us stick to conclusions supported by data.  There is a strong inverse relationship.  If you are a trader, you had better pay attention.  If you are a long-term investor, you need to understand the long-term relationship.

Meanwhile, I invite reader comments, citations for new data, and fresh hypotheses.  I will pursue this for at least one more article, considering various causal models.

Comments

[stock market news]

This Stock Blog gives insight on daily stock market trading as well as stock trading analysis and technical analysis of the Stock Market and individual stocks making the news. We don't give Stock Picks ( I guess the stocks that I buy are stock picks ) but we do give stock alerts on the best stocks to watch and the hottest stocks to trade daily. stock market live Stock trading blog

[forex trading journal]

Truly appreciable post if I don’t appreciate you it should be my mistake or something disappointing for you. Great job keep it up.

[oldprof]

Tim -- I am not quite sure what to say, except that I encourage you to read the article again and also to follow the link to the prior piece in this series.

This article is an objective analysis of data. The conclusion is that dollar strength is correlated with higher market prices in the long run, a conclusion you seem to favor.

There are a lot of viewpoints about the relative dollar value, all of which you will see if you follow the link.

Thanks,

jeff

[Tim]

There is an inverse relationship, but you are going nowhere fast.

Say $1US is equal to $1EU

The dollar then loses half its value against the EU.

Because of your inverse relationship the US stock market doubles in $US since the currently lost half.

In $EU the stocks still have the same value (twice the price in dollars worth half as much).

A weak currency is bad. Show me a prosperous county with a crappy currency.?? China is booming and the currency would rise except for China's meddling. Europe is dying and so is the Euro. This is not an inverse relationship.

[Michael Weiss]

interesting article

I agree with your inverse relationship.

Thank you for your post.

[Ron Stone]

Interesting point. I would never had agreed except for the hard data you present. I do however believe the dollar is going lower, perhaps much lower. With all the money the Fed is pumping into the US economy, I don't see how it could go any other way.

[graspthemarket]

I'm in agreement with your inverse relationship. There has been a correlation since the market’s bottom, and I confirmed that point-of-view by watching hours of how the US futures (including silver) reacted against the dollar. For example, when the dollar weakened, silver rallied. As I noted in the “Bottom Line” section of the site, during the Tuesday overnight futures session, the dollar fell about .75% compared to the Euro. In the past, SLV would have opened on Wednesday morning by that percentage or higher. However, on Wednesday morning, silver was up only .05% at the market open. This information proved to be useful because this may have signaled a turn in the market. The next trading session on Friday showed a dramatic drop in SLV along with the rest of the markets. SLV was down more than 3%. Silver has been holding onto the up sloping trend line from its bottom. The trend line appears to be very accurate because silver keeps hitting it. A strong break of the trend line would confirm the Sell-Off action on Friday. I show a chart of this here:

http://www.graspthemarket.com/elliottwave/20091130a.php

[graspthemarket]

I updated my view on the dollar and silver here. http://www.graspthemarket.com/articles/20091122a.php I confirmed many of the feelings above just by watching the overnight futures on tv and at the same time watching a carry trade play out. Amazing what is going on.

[Mitch (Hate my zero radius sink) Nelson]

Interesting article, thanks so much for this post.

[Colin Martin]

Jeff,

Don't have the same data set as you but I believe there is strong inverse correlation between DXY and S&P500 from 2001/2002 onwards not just recently. Longer term there is no apparent correlation due to the sign of the correlation changing in 2001/2002 timeframe. Suspect post 9/11 interest rate policy is a potential root cause.

[graspthemarket]

I think silver is more telling than gold in terms of the US dollar. I discuss my point here. scroll down on the page to read the article about my view on silver.
http://www.graspthemarket.com/articles/20091115a.php