Many traders perceive the correlation between the US stock market and the dollar index as negative. Two main reasons contribute to the prevalence of this idea. The first reason is fundamental, while the second is more practical. In this article, we will delve into the fundamentals of the correlation between the dollar index and the stock market and explore how traders can leverage this information to navigate between market cycles.
(S&P 500 – Dollar Index, Last Year)
The first concept behind the negative correlation between the dollar and stocks is fundamental. When the dollar loses value, the volume of overseas sales for firms increases because the affordability of US goods and services improves outside the US. Additionally, imports to the US are expected to decline, which leads customers to turn to local firms. Both of these conditions result in increased profits for US firms, leading to higher stock prices.
The second concept is more short-term and practical. Usually, when EURUSD falls, stock futures begin the day more negatively, or when the US stock market opens strongly, EURUSD gains from this positivity. This reinforces the idea of a negative correlation between the dollar and stocks, particularly among price-action traders.
Both concepts are mostly correct, but is the negative correlation really the correct scenario? Looking at the chart above, we can observe the last year’s dollar index, S&P500, and the 22-day correlation between them. As you can see, they mostly exhibit a negative correlation, except for three months.
(2021-2023 S&P500 – Dollar Index Regression)
Looking at another period, from 2021 to 2023, the dollar and S&P 500 exhibit a negative 62.5% correlation, with the dollar as the independent variable. Despite the correlation, the distribution is not even close to a normal distribution, which raises some questions. During this period, the economy is on the path to recovery, inflation remains high, and the Fed is in a hiking cycle. Rising rates have a negative effect on stocks and a positive effect on the dollar due to decreasing money supply growth. Markets anticipate tight financial conditions to persist during this period.
(2012-2020 S&P500 – Dollar Index Regression)
Looking at the pre-COVID period between 2012 and 2020, the dollar index and the stock market exhibited a whopping 71.5% positive correlation. Despite still not being evenly distributed, this correlation contradicts the negative dollar-stock idea. So, what was different back then? After the 2008 crash, despite a significant increase in the Federal Reserve balance sheet, the dollar index enjoyed a good run due to increasing demand for money supported by stable economic growth. Market sentiment remained relatively high during this period with stable growth, leading to good returns for both stocks and the dollar.
(2008-2012 S&P500 – Dollar Index Regression)
Now we know what to expect during stable growth and a rate hike cycle. But what happens when the Fed becomes extra dovish? During the 2008–2012 period, the dollar and stocks exhibited a negative 73.6% correlation, much higher than the other two cycles. The distribution is also much more evenly spread. After the crash, stocks experienced a dip, and the Fed loosened its policy, causing stocks to recover while the dollar remained lower.
(S&P500 Daily Chart)
So, looking at the long term, the correlation between the dollar and stocks isn’t too strong because it changes significantly during certain economic cycles. Basically, when the economy is growing steadily with inflation close to the Fed’s target, the correlation between the dollar and the S&P 500 is positive. However, when the Fed is tightening or loosening financial conditions, the correlation turns negative.
For a couple of quarters, US growth has been steadily above the long-term average, and despite being high, the Fed did not significantly change rates. The correlation turning positive might signal that market participants expect stable growth to continue for a while. If there is a chance of a soft landing comes under risk or if the Fed starts to cut rates aggressively, we may see the correlation turn negative. This correlation will possibly provide a relatively clear indication of market sentiment about the economy.
