Ramblings of a Portfolio Manager

Why must the US Stock Market be a slave to the US Dollar?

Lately, one cannot help but turn on a business news channel and hear, at least a dozen times during the broadcast day, a report on the US Dollar Index (USDX) and its real-time impact on stock prices. More often than not we are presented with an intraday chart of the USDX versus the S&P 500, which explains with near perfect reliability why stocks have strengthened or weakened in the last few moments—always the inverse of the immediate movement of the dollar versus a basket of currencies. We hear and read about this relationship so often now that, in fact, that most newer market participants take it for granted that US equities must always be negatively correlated to the value of the US dollar versus other currencies, a fact that is certain to turn this relationship into a self-fulfilling prophecy for the short run. But does this need to be and has it been so in the past?

The USDX is an index of the value of the US Dollar versus the exchange rates of six major world currencies: the Euro, Japanese Yen, Canadian Dollar, British Pound, Swedish Krona and Swiss Franc. The index started in 1973 and was revised in 2000 with the creation of the Euro. It began with a base of 100 and all movements of the Dollar versus that basket of currencies is relative to this base, so a value of 125 would mean that the U.S. dollar increased in value by 25% since 1973. The index reached a high of over 120 in 2002 and since that time has been in a more or less steady decline. Over the last year the index has declined from a high around 88 during March 2009, at the height of Market fear when the dollar was sought as a safe haven, to a low of 74 in November of 2009. Since November, however, the index has rebounded to around 80 as hopes of a US interest rate rise, combined with a safe haven move on fears of a Greek default, have bid up the Dollar. Over this recent period the Dollar has indeed shown a nearly perfect negative correlation to US stock prices with a coefficient of -0.81 for 2009 and -1.0 (perfect negative relationship) for the last 12 months, meaning US stocks have moved almost in lock step with the dollar but in the opposite direction.

This correlation is atypical, however, and historically a strong dollar was seen as an indicator of a healthy and strong US stock market. A little history: From 1995 to 2000, both the Dollar and the US markets rallied, a positive correlation. From 2000 to 2002, the US markets suffered a big decline and so did the Dollar, also a positive correlation. From 2003 through 2004, however, the markets rallied while the Dollar lost, a negative correlation. In 2005, the Market was fairly flat and the Dollar rose while in 2006, the Market rallied and the Dollar lost. In 2007, the US Market gained but the Dollar suffered a big decline and in 2008, the Dollar initially lost ground while the Market rose slightly but then spiked late in the year when the financial crisis hit and the dollar became a safe haven while the Market sank. The results of this longer term analysis is that the USDX and US equity markets actually have a weak but positive correlation of about +0.35.

So why has the dollar been a strong negative driver of stock prices over the last 18 months? The answer has to do with the absolute level of interest rates in the US. With the drastic Fed easing cycle US rates are near zero and global investors seeking higher returns have been borrowing in dollars to invest in higher yielding instruments such as stocks and commodities--the so called carry trade--leading to a strong inverse relationship between the S&P 500 and the USDX. We’ve seen this pattern before and perhaps there is a history lesson there. In 2004 we also saw a large inverse relationship between the S&P and the Dollar with a correlation coefficient of -0.71. The Dollar Index fell 7% that year while the S&P gained 9%. Back then, as today, interest rates were extremely low during a Fed easing period that led to a Fed Funds target rate of 1%. At the end of the cycle, as the Fed began to raise rates on a strengthen economy, the relationship weakened and as the economy picked up the strength was enough to keep the stock market rising, even with a rising dollar. The current environment feels a lot like the end of 2003 and we suspect that, with Bernanke at the helm of the Fed, future rate rises will be measured enough to allow continued strong economic expansion in the face of rising rates. If that is the case, then history tells us that further gains for both the Dollar and US markets lie ahead.