The Changing Correlation Between the U.S. Dollar and the Stock Market

The correlation between the U.S. stock market, typically the S&P 500 Index, and the U.S. Dollar (USD) has never been simple and now it is undergoing a definite change.

To investors, it is important to know whether the USD is a safe haven or a funding instrument to predict market movements.

The Long-term Connection

In the long term, the relationship between the USD and U.S. equities has been slightly positive, yet weak.

• Positive Correlation (Weak):
  • Over the two decades, there has been a weak positive correlation, which is primarily due to capital flow: the increased global demand for U.S. stocks compels foreign investors to purchase USD first, which increases the value of the USD.
  • That, in turn, boosts the USD demand, which boosts the currency and the stock indexes.
• Sectoral Impact:
  • This relationship is not consistent across all companies.
  • Strong Dollar: Generally favors domestic-oriented companies and importers since a stronger USD makes foreign goods and raw materials cheaper.
  • Weak Dollar: Favors multinational exporters, with a weaker USD making U.S. goods more competitive in the foreign market and converting foreign sales into more USDs, increasing reported earnings.

A Recent Shift to an Inverse Correlation

Since the early 2000s, particularly in fluctuating economic periods, the correlation has been inversely correlated (negative), as the USD and the S&P 500 have been moving in opposite directions.

• Risk-On/Risk-Off Dynamics:
  • This negative trend typically indicates the way investors respond to an increase or decrease in risk appetite.
  • Risk-On Environment (Stocks Rise): Investors are confident, and they pursue higher returns in foreign markets, selling the low-yielding USD to purchase riskier international securities. This outflow undermines the USD and stocks increase. This is a tendency, and not a rule.
  • Risk-Off Environment (Stocks Fall): When the world is in crisis or facing high uncertainty, the global investors shun risk and buy USD as the world’s reserve currency. This demand boosts the USD and stocks could also feel downward pressure.
• Monetary Policy and Funding:
  • This negative relationship has been exacerbated by the current Fed policy of long-term easy money.
  • The low-value USD is extensively employed as a financing currency to fund positions in higher-yielding assets and it is constantly exerting a downward pressure on the USD as the world equities increase.

FIGURE 1: USD Index vs the S&P 500

The Outlook for a New Structural Phase

Long-term cycles are also considered to be the movements of the USD, which typically take seven to ten years to complete.

The USD up-cycle that started in 2008 appears to have reached its peak, and the currency might be in a multi-year weakening period.

• Valuation:
  • The USD is also estimated to be overvalued against major peers, despite recent depreciation, which suggests a difficult long-term path.
• Global Leadership:
  • The historical pattern of USD strength coinciding with U.S. stock performance and USD weakness coinciding with international stock performance (ex-U.S. equities) suggests that this cyclical reversal is already in progress.

The data indicates that the traditional, weak positive relationship was overtaken by cyclical effects and a structural change to USD weakness. This renders the recent inverse relationship more important for investors to keep an eye on.

To explore the relationship between the USD and other asset classes further, you may watch this video: The US Dollar Is Weak. Is Your Portfolio at Risk?.

It talks about the consequences of a falling USD on diversified portfolios and other safe-haven assets such as gold.