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Want a solid grasp of inter-market relationships in 10 seconds? Here it is:
Just follow the S&P 500 Chart, in whatever time frame you trade or invest.
A Brief Explanation
  • Most asset markets follow the moves of global stocks, either moving in the same or opposite direction, but deriving that direction from global equities. That’s because equities are the best overall picture of global risk appetite (so much so that the movements of global stocks and risk appetite are virtually one and the same)
  • The S&P 500, as the most representative index of the US stock market, still the world’s single largest stock market, is the one chart that best summarizes the prevailing sentiment, be it positive (aka risk appetite or optimism) or negative (aka risk aversion or pessimism).
  • In general, in the short term the S&P 500 also drives the direction of currency value, especially that of the most liquid one of all, the USD. In sum, it is truly the One Chart to Rule Them All (yes, yes, of course there are exceptions, qualifications etc. Please, I’m trying to keep this simple for the lay-traders).
  • Many commentators wrongly believe the opposite, that a weak USD drives stocks higher, due to cheaper US exports and inflated US multinational earnings from foreign revenues, and a strong dollar drags them lower. By the same logic underpinning this belief, European and Asian stocks should behave in the opposite manner, as a weak USD hurts their exports and earnings. In fact European and Asian stock markets move in the same direction as the S&P 500 relative to the USD. That is, when they rise, the USD falls, and vice versa. So what is the real relationship between the USD and stocks?
  • Risk appetite/optimism about economic recovery and growth is best reflected in stocks. When there is optimism, i.e. rising stock markets, that causes traders to buy higher yielding currencies and sell/borrow the low yield USD (and a few others, but especially the USD) to fund these purchases at low interest, hoping to profit on the interest rate differential. In effect they are "shorting" the USD. When fear--aka risk aversion--rises, traders unwind these trades and buy back the USD, causing the USD to rise like a shorted stock. THUS STOCKS USUALLY DRIVE THE USD AND OTHER FOREX PAIRS, NOT VICE VERSA
The One Chart That Rules Them All Rules the USD Too-Though Many US Stock Commentators Don’t Get It
In other words: Equities Generally Drive the USD and Other Currencies , Not Vice Versa.

Many US stock pundits still don’t get it. Many believe the USD is a primary cause of movements in the S&P 500 and other major stock indexes.

For example, look at the US stock market summary of the November 25th US stock market action published on Yahoo! Finance from Briefing.com, which opened with the following statements.

A new 52-week low for the Dollar Index [emphasis
mine]and a generally pleasing batch of economic data helped stocks make their way higher….

Renewed pressure against the U.S. dollar sent the Dollar Index to a 1.1% loss, its worst single-session percentage drop in nearly four months. The drop also put the Dollar Index at a fresh 12-month low, but gave a broad lift to the equity market.

In other words, a weak dollar lifts stocks, and vice versa. In general, the opposite is in fact the case, stocks drive the USD and other forex, not the other way around.

This confusion is somewhat understandable if one considers the perspective US based, US-centric stock commentators who don’t fully do their homework. Why?

What Confuses Many US Stock Pundits
  • If one focuses ONLY on US stock market movements and USD movements during US stock market hours, the negative correlation (tendency to move in opposite directions) occurs simultaneously, so the real cause/effect relationship isn’t clear on a superficial level.
  • Forex Does Affect Equities Over the Longer Term: It’s true that forex does affect equity markets, however this influence is usually over the longer term. One reason for this is that longer term forex trends influence interest rates over a longer term, which in turn influences demand for equities. Conversely, stock market movements tend to have immediate impact on currency markets. Much of the reason for this is that 80% of currency trading is speculative, mostly very short term from minutes to a few days. A much larger proportion of equities tend to be held for longer periods.
There ARE reasons a weak USD might move stocks in the short term. This reasoning is seductively simple:
  • A rising dollar makes US exports more expensive and less competitive, lowering earnings expectations. This is correct. Forget for a moment that it makes US imports, and America IS a net importer, cheaper and key imported imputs like oil cheaper, at least in theory.
  • A rising dollar makes US multi-national earnings in foreign currency worth less, thus also lowering earnings expectations. This is also correct. Again, suspend any thoughts that a stronger dollar makes foreign currency denominated expenses cheaper.

While we’re being easy on poor stock market pundits, please also put aside any thoughts about the potentially disastrous effects of a long term decline in the US dollar on the US economy (and US corporate earnings, because 70% of US GDP is domestic consumer spending), how it will ultimately drive up the interest rates that the US government must pay to finance itself, interest rates in general (goodbye housing market, bank credit risk, banks, housing related jobs, etc), and the effects of the dollar ultimately losing its reserve currency status (far less demand still for the USD). What the heck.

WHY THE ABOVE REASONING IS WRONG

However, if a weak dollar is good for US stocks for the above reasons, it should be bad for Asian and European stocks for the same reasons. That is:

  • A weak US dollar makes exports from these regions more expensive and less competitive, and should thus lower earnings expectations seriously. The US is still one of, if not the, largest customers for these regions.
  • A weak US dollar makes the dollar denominated earnings from sales in the US, (again, often the biggest single customer they have) from these exports worth less, again lowering earnings expectations. In the case of commodity exporters, this is an especially serious problem unless commodity prices rise (and they don’t do so easily when the growth picture gets negative and stocks fall) because their commodities are typically priced in dollars.

Thus by the same reasoning that says a weak dollar is good for US stocks and a strong dollar is bad for them, then Asian and European stocks should be falling when the US dollar falls and rising when it rises. In other words, they should correlate positively with the USD. Rising when the USD rises, and falling when it falls.

Indeed, the positive effects of a weak USD should be more pronounced, because most economies in Asia and many Europe depend on exports for a far larger portion of their GDP than the US, which derives most of its GDP from domestic consumer spending.

As an analyst who lives seven hours ahead of EST, and watches all major global stock, forex, and commodity markets, especially during the hours in which Asian and European equities markets are open, I see things many miss.

Here’s a key observation that anyone in the markets must understand:
In fact, major Asian and European stock markets share the same multi-day (and longer) trends that US stocks show, moving in the opposite direction of the USD. That is, when Asian and European stocks are rising, the USD is falling, just like is does with US stocks.

That all global stocks in general are rising while the USD falls suggests that the reasoning behind the "dollar as a major mover of stocks" is wrong, because a weak USD should be hurting non-US stock markets by the same reasoning used by those who claim it helps US stock markets.

THE USD HAS BEEN IN A DOWN TREND SINCE MARCH 2009
Let’s examine the below charts (click on all to enlarge) and how the USD and Global Stocks have moved over the same periods.
Here’s a chart of the UUP, an ETF that rises with a rising USD and falls with a falling USD:
UUP Daily Chart : Note how it’s been falling since the March Rally in Global Equities Began (08 Nov 25)
Note how the USD has been falling since early March, the same time that global stocks began rallying.

For another example of the USD’s fortunes, here’s a daily chart over the same period of the EURUSD, perhaps the forex trading pair most representative of the USD’s fortunes, because this pair alone comprises about one third of all forex trades. Thus every third forex trade is this pair, and for every 3 Euros bought or sold, a USD is used, and vice versa.

Here too, note how the EUR has gained over the USD, meaning the USD has been weakening during this period against other pairs. Check any major forex pair you want, the trend is indeed the same – weakening USD.

EURUSD Daily Chart 3/09—11/09 (06 Nov 26) Chart Courtesy of AVAFX.com

Thus for those not aware of it, since March, the USD has been losing value and in a steady down trend against other major currencies.

EXAMPLES OF INTERNATIONAL STOCK MARKETS RISING WHILE THE USD FALLS
Meanwhile, not only has the S&P has been in a strong uptrend, but so have most other major international stock indexes.
European Stock Indexes
For example, look at a daily chart of the DAX, the main German stock market index (click to enlarge)
Daily Chart DAX 3/09—11/09 (07 Nov 26) Chart Courtesy of AVAFX.com
Here’s a daily chart for the CAC, the main French stock index (click to enlarge)
Daily Chart CAC 3/09—11/09 ( 08 Nov 26) Chart Courtesy of AVAFX.com
Here’s a chart for the FTSE, the main UK stock index (click to enlarge):
Daily Chart FTSE 3/09—11/09 (09 Nov 26) Chart Courtesy of AVAFX.com
Note how all have similar up trends to that of the S&P 500.

Asian Stock Indexes

The same trends have held for the Asian markets, for example this chart of Hong Kong’s Hang Seng (click to enlarge). Considering the negative effects of a weak dollar on Chinese export earnings, this chart should not be showing such a strong uptrend if in fact the reasoning applied by US stock pundits held true. If the dollar was driving stocks, this and other charts of Asian export economies should be more of a mirror image of the S&P 500 rather than a similar and sometimes more strongly up-trending version

Daily Chart Hang Seng Index 3/09—11/09 (10 Nov 26)
THE TRUE RELATIONSHIP REVEALED: WHY STOCKS IN FACT USUALLY PROVIDE DIRECTION THE USD AND FOREX TRADE IN GENERAL
When Asset Markets Are Optimistic, Currency Traders Sell Dollars

Global stocks, arguably best represented by the S&P 500, are widely believed to be the best barometer of optimism about growth prospects, aka risk appetite, or pessimism, aka risk aversion.

When there is risk appetite, traders buy currencies that tend to rise when there is growth (for a variety of reasons, but mostly because these offer the highest short term yields). These are referred to as risk currencies, because they tend to rise with risk appetite. (The main ones being the AUD, NZD, EUR, and CAD).

When Stocks Markets Retreat, Currency Traders Buy Back Dollars (also JPY and CHF), Thus Misleadingly Labeling these "Safe-Haven" Currencies.

When there is fear or risk aversion, the risk currencies are sold and traders buy back the low yielding currencies used to fund these purchases, thus these low yielders tend to rise in times of fear. Thus this group is known as the safe-haven currencies. The USD has, over the past few years, generally been the #2 most in-demand safe haven currency, after the #1 JPY, though recently it has arguably become #1 currency bought in times of fear.

These Labels Refer to Market Behavior Only, Not Fundamental Store of Value Safety

Understand that these labels do NOT at all mean that one currency is actually a better or less reliable store of value than another, indeed some of the "risk" currencies have much better fundamentals than the safe havens, and are backed by far healthier banking systems that are largely unburdened with bad debt, unlike the USD.

Rather this nomenclature simply refers to how the currencies behave in times of optimism of pessimism.

Because risk and safety assets tend to move in opposite directions at the same, which asset influences which is not always clear to casual observers. To further complicate matters the roles do at times briefly shift, and the primary forces that drive a given currency price can and do change over time.

Conclusion: Short Term Movements In Stocks Drive Daily Currency Movements, Whereas Currencies Generally Influence Stocks Over a Longer Period

Short term currency moves thus generally have little short term influence on stocks, whereas short term stock market movements have immediate influence on currency pair prices.

This is true for all economies to varying degrees, though in fact ironically far less so for the USD, since most of US GDP is from consumer spending, NOT exports. As a net importer, when the US economy is healthy and importing, the US economy reaps benefits, especially in the short term, from a strong USD because the imports become cheaper.

However, about 80% of currency trade is from very short term speculative traders, and in the short run, they look to the direction of stocks to decide whether to go long or short on the risk currencies or safety currencies.

The above article has attempted to present a complex topic in simple terms, and thus inherently suffers from certain oversimplifications. Historically, currencies trade based on the same fundamentals that influence their local stock markets, and thus have often move in the same direction.

That has not been the case since the current crisis began. Until there are deep improvements in the fundamentals of the US economy that will allow the Fed to raise interest rates, the USD is likely to continue to move in the opposite direction of stocks, as are other low yielding currencies like the JPY and CHF (the CAD has fundamental underlying differences from these that allow it to trade in the same direction as risk appetite / stocks despite its low yield).

Since the current downturn began, the USD started trading as a safe-haven currency, i.e. one that traders buy ONLY in times of rising fear. Without getting too much into the technicalities of why this is the case (like that it’s used as a funding currency of carry trades) suffice to say that it behaves this way due to the USD’s poor fundamentals, including:

  • Low income: low short term yields that are likely to be among the last major currencies to rise, thus one gets very low returns from holding low risk USD debt.
  • Low chance of capital gains due to (at least perceived) ballooning supply that is widely believed to virtually guarantee inflation/devaluation, thus making the USD a poor holding for capital appreciation.

Thus the only reason to hold the USD at this time is that it DOES tend to rise when there is risk aversion. Because stocks are currently seen by currency traders as the prime barometer of risk appetite, the safe-haven USD falls when stocks rise and vice versa when they come in.

Author's Disclosure: No positions in the above instruments.
Source: The Must-Know Connection Between Stocks and the USD