How an Increase in the Dollar Affects the Stock Market

For short-term traders as well as long-term investors, the relationship between the value of the U.S. Dollar and the stock market is one of the most significant. It can be used to anticipate future moves in the near-term, making it well-suited for determining entry and exit points, as well as being a driver for overall market sentiment.

While there are many permutations to this relationship, in general the value of the dollar will have either a positive or inverse correlation to the stock market. In situations where a positive correlation exists, this means that as the value of the U.S. Dollar rises, so too do stock prices. When an inverse correlation exists the opposite is true -- as the U.S. Dollar rises, stock prices fall.

It is very common for these correlations to pivot over periods of time. The reason for these flips are attributable predominantly to changes in fundamental indicators for economic markets as a whole. As such, the U.S. Dollar to stock market correlation functions as a practical gateway for bridging the overall fundamentals of the market with the more specific technical aspects associated with the execution of trades in narrower time frames.

Before the Dollar to stock market correlation can be understood further, it is important to know how to find it and how to monitor it. While this correlation can be calculated using the charts of many different financial instruments and indices, the most common way is to do a chart overlay of the U.S. Dollar Index (DXY) and the S&P 500 Index (SP500).

Both of these indices respectively offer a precise barometer of the individual strengths of both the U.S. Dollar and the stock market in general. The DYX is a weighted index that measures the U.S. Dollar against a basket of foreign currencies based on the amount of trade conducted between the Dollar and each of those foreign currencies. By using these two indices, it allows for a more accurate measurement of the correlation.

The correlation between the Dollar and stock prices, even when the direction has been clearly identified as being either positive or inverse, can vary. The correlation coefficient is used to gauge how strongly correlated the relationship is.

An ideal positive correlation would be measured with a correlation coefficient of +1. This would indicate that every rise in the Dollar is matched precisely by an equal rise in the stock market. A correlation coefficient of -1 is the ideal example of an inverse correlation. For every rise in one instrument, there would be an equal decrease in the other.

In the real world, however, such consistent ideal examples of correlations rarely exist for too long. With the U.S. Dollar and stock prices, any correlation coefficient above 0.50 indicates the presence of a strong positive correlation. This means that 50 percent of the stocks are moving in tandem with the U.S. Dollar. A correlation coefficient of -0.50 or lower is an indication of a strong inverse correlation. This means that fifty percent of the stocks are moving opposite to the movements of the Dollar.

This degree of correlation is important to note because it is indicative of how individual stocks are affected differently by changes to the value of the dollar. While the correlation between these indices is a good indicator of the current prevailing directional trend and market sentiment as a whole, it might not provide as accurate of a picture when it comes to gauging specific market sectors or individual stocks.

Even if the correlation coefficient were to be 0.75, indicative of a very strong positive correlation, that would mean that only 75% of stocks are moving in pace with the dollar. The remaining 25 percent of stocks could be lagging behind or be moving opposite to the Dollar.

Bottom line, correlation between the Dollar and the stock market should be used to gauge overall trends and sentiment, never as a stock specific indicator.

Looking at a comparison chart of the DXY and the SP500 over the last fifty years, it is evident that during that time frame the 52-week rolling correlation between the U.S. Dollar and the stock market has changed from positive to inverse, or vice versa, a total of ten times. While there is no magic formula for determining when these correlation shifts occur, they are heavily influenced by inflation, interest rates, commodity prices, risk sentiment and geopolitical conditions.

In situations when economic growth in the U.S. is being driven by foreign demand for goods and services, the U.S. Dollar has a tendency to appreciate. This appreciation has the effect of making imports cheaper to U.S. businesses and consumers. This in turn frees up discretionary spending that will result in higher domestic demand for goods and services as well. Extrapolated over a period of two to five years, and in order to mitigate the potential for inflation under such circumstances, interest rates would have to rise; further driving up the price of the Dollar. It is during conditions such as these when a sustained positive correlation exists between the Dollar and stock prices.

Eventually, especially when the final stage involving rising interest rates is reached, a pivot may occur resulting in an inverse correlation. Economically this can be explained by the fact that as the Dollar appreciated, eventually it became too expensive for the same foreign entities that had originally driven the demand for U.S. goods and services. This coupled with the added cost of borrowing money by rising interest rates creates an economic slowdown which in turn is a negative for the earnings of U.S. companies. This results in dropping stock prices. As such, the Dollar rises as stock prices fall.

As has already been mentioned, the U.S. Dollar to stock market correlation can and will change change. Presently, however, as we go past mid-2016 the current correlation is inverse. This has been the case throughout most of 2015 and into 2016. The driving force behind this current inverse correlation is the market's predominant view that economic growth is reliant on the availability of cheap money. Specifically, any rise in U.S. interest rates by the Fed would be seen as stifling to economic growth and as a result negative to corporate earnings.

At the same time, the anticipation of an interest rate hike by the Fed has caused the U.S. Dollar to appreciate. Add to this the demand for the U.S. Dollar as a safe haven and reserve currency caused by the fear and turmoil brought about by recent economic tsunamis, such as the Brexit vote, and the Dollar rises as the stock market falls.

Incredibly, as worldwide economic turmoil increases, the markets take this as a reason for the U.S. Fed to reconsider any potential interest rate hikes and this results in repeated recovery rallies by stock markets as the Dollar drops.

While this data can be interpreted many ways, the prevailing view is that the inverse correlation between the U.S. Dollar and stock market prices should continue until the Fed has asserted itself and commits itself to multiple rate hikes. Under the current economic paradigm, this will likely not begin to happen until sometime in 2017. As such, the inverse correlation is likely to persist until that time. When the Dollar rises, stock market prices will fall. When the Dollar drops, stock market prices should rise.