The Inverse Relationship Between the Dollar and Stocks

With interest rates nearly at zero percent in the U.S., global investors seeking higher risks and returns are borrowing dollars to invest in higher yielding instruments such as stocks and commodities leading to a strong inverse relationship between the S&P 500 and the Dollar Index in 2009.

The Dollar Index, a measure of the dollar against a basket of six leading currencies (EUR, JPY, GBP, CAD, CHF, SEK) is trading at a 15-month low, as it tumbled on Wednesday November 25 to an intraday low of 74.23, its weakest level since 8/7/08. In the past week, the dollar fell to a 14-year low against the yen as it traded around 84.92 Japanese yen per USD on 11/27, its lowest level since July 1995, and down ~3.7% year-to-date. The dollar is also significantly weaker against other major currencies such as the euro, trading well above $1.5 per euro in recent trading sessions and falling to a 15-month low against the currency. The euro has appreciated ~7.8% against the dollar year to date.

The inverse relationship between the dollar and stocks is statistically significant with a negative correlation coefficient of -0.81 for the year and almost a perfect -1 in recent months. This is atypical when compared to other points in history. For example, the correlation coefficient was only -0.43 in 2008. See the chart below how the two move opposite one another, particularly since the summer.

Looking back over the past decade, 2004 was also a notable year that showed a large inverse relationship between the S&P and the Dollar with a correlation coefficient of -0.71. The Dollar Index fell -6.98% that year while the S&P gained 8.99%. Like today, interest rates were notably low towards the end of 2003 to mid 2004 as the Fed had an easing period that led to a Fed Funds target rate of 1%. As the Fed began to raise rates, the relationship weakened. Fortunately, the economy had picked up enough to keep the stock market rising, even with a rising dollar.

According to the central bank’s FOMC Minutes in late November, rates are suppose to remain low for an “extended period of time”, meaning that the dollar could continue to depreciate until the Fed’s begins tightening. Many analysts expect that rates may not increase until the second half of 2010. If the relationship holds, stocks may have more room for growth.

Not only has the dollar vulnerability contributed to stronger US equity performance, but it has also buoyed currency ETF’s. ETF’s such as CurrencyShares Australia Dollar Trust and Wisdom Tree Dreyfus New Zealand Dollar Fund are up 29.9% and 26.2% for the year so far. (See table below for a list Currency related ETF’s and YTD performance)

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