Any Value in Correlation Between the Dollar and Equity Markets?

by: Dr. Ken

Lately, a great deal has been made of the high degree of negative correlation between the dollar and the equity markets. But this is not unusual; a strong dollar usually coincides with an upward trend in the equity markets, and vice versa. The fundamental reasons for this relationship are straightforward and among them is the observation that a falling dollar makes the price of US products more attractive abroad, increasing exports for US firms.

The following chart illustrates this relationship between the US Dollar Index (“USDX”) and the ETF “SPY” (as a surrogate of the equity markets) over the 11-year period since the introduction of the Euro.

click to enlarge

SPY and USDX Adjusted Prices Over 11 Years

Note that the two indices have moved in opposite directions over the majority of this time frame. As the USDX rose, SPY fell, and vice versa. What is unusual, however, is the decoupling of this relationship during the first half of the last 12 months, illustrated below.

SPY and USDX Adjusted Prices Over The Last 12 Months

The dollar and the equity market moved in absolute unison between October 2009 and April 2010. This highly positive correlation is what is unusual, not the negative correlation we are currently observing.

Two observations are important. First, equities fell precipitously beginning with the downgrading of Portuguese debt, and the dollar continued to march higher. Second, the dollar began to turn negative in June, and equities rose. Even the transient drop in equities during mid-summer coincided with a rise in the dollar; further evidence of resurgence of the negative USDX:SPY correlation.

The USDX is determined by the weights of the currency exchange rates of the dollar with 6 currencies, the Euro, the pound sterling, the Canadian dollar, the yen, the Swedish kronor, and the Swiss franc. But the Euro is weighted considerably more than the others, accounting for fully 57.6% of the USDX (the next is the yen at 13.6%). Over the 11-year period, the dollar has been more highly correlated with the Euro than wiith any of the other currencies.

What happened to the Euro in mid-2010? Well, it rose from a low of approximately 1.20 to as high as 1.40. Why? Possibly investors regained confidence in the global economy, arresting the flight to quality that was previously responsible for the stronger dollar. As well, the looming QE2 surely weakened the dollar – at least in anticipation of the Fed printing hundreds of billions to buy treasuries. The logic was that the demand for the treasuries would rise, yields would increase, interest rates would fall, and the dollar would become devalued as less desirable currency (in actuality, this did not occur upon release of the QE2 details).

Can any of this information be of value in trading? Said differently, can the change in the USDX be used to make short or long decisions when trading equities? One way to answer this question is to determine if there is any correlation between the change in USDX and the future performance of SPY. Below is a data table that illustrates the correlation coefficient between USDX and SPY between 1999 and 2010. The USDX historical change over “Y” preceding trading days appears down the first column The SPY one-month forward return, beginning (lagged) “X” trading days in the future appears along the top row.

 Correlations of USDX:SPY - Rows = subsequent TDs, Columns = forward TDs

The correlation coefficient is best (-13.8%) when “Y” is 19 days and “X” is 1. In other words, there is roughly a -14% correlation between the USDX change over the preceding 19 trading days and the subsequent SPY return the following 22 trading days (about one month). When USDX rises, SPY tends to fall, more often than not. While -14% is not very impressive (for instance, the correlation between the SPY return one trading day and the SPY return the next trading day is about -12%), it implies that a decrease in the strength of the dollar predicts an increase in the equity markets over the short term. Just one more tool to add to the box.

Disclosure: Long or short positions in SPY, FXY