As the problems in the eurozone continue to dominate financial headlines, many pundits talk about the strong correlation between the euro (FXE) and the stock market (SPY). However, many fail to correctly explain the relationship between the euro and stock market. Rather, it is often said that a weak euro means trouble for the stock market. While this is sometimes true, it is certainly not always the case. In this piece written in November 2011, I discussed why a weak euro could be a major positive for the stock market. Tuesday's trading session can provide interesting insight into the relationship between the euro and stock market.
Source: Yahoo Finance
During the morning, the euro (shown in blue) and the stock market (shown in green) were both very strong. However, by mid-day, the euro started moving lower on bad news regarding Spain. Initially, the stock market also started to move lower. However, even as the euro continued moving lower, breaching the key level of $1.25, the stock market stabilized and later rallied to close near the sessions highs. This action shows that while the euro and stock market can at times move together, the relationship is not as strong as some often assert. Traders who were looking at the euro for a direction indicator on the stock market did not have a good day.
When A Weaker Euro Is Good For Stocks
As mentioned in my previous article, a weaker euro can be good for stocks. For example, if the euro is trading down on hopes of action from the ECB to lower interest rates or initiate other "easy money" measures such as the LTRO, the stock market will rally. As shown below, this was what happened in late 2011 and early 2012. The euro moved lower while the stock market moved higher.
When A Weak Euro Is Bad For Stocks
While a weak euro can sometimes be bullish for the stock market, this is not always the case. When the euro is going down on fears of an EU breakup, led by a Greek exit from the euro (and as has been the case over the past month) the stock market will also move lower. The chart below shows the close relationship the euro and stock market have had over the past month:
When A Strong Euro Is Bad For Stocks
It is often said that a strong euro is good for stocks. However, there does exist a case where a strong euro is a negative for stocks. If Greece and other weak nations decide to leave the euro, it will be a negative event for global growth and the stock market. On the other hand, if weak nations leave the euro, it will become a much stronger currency that looks increasingly like the Deutschemark. During the summer of 2011, when the stock market was getting hit hardest, we did see a situation where a stronger euro was bad for the stock market as the euro was strong because the ECB refused to ease policy.
When A Strong Euro Is Good For Stocks
It is often the case that a strong euro is good for stocks. There are a few reasons for this. Firstly, the euro moving higher against the dollar is a traditional hallmark of the "risk on" trade, as interest rates in the eurozone are still higher than interest rates in the U.S. Additionally, at times, the euro rallies on hopes that the eurozone will bind closer together in some form of fiscal union led by Germany. As shown by the chart below, this relationship between the euro and stocks existed from late 2010 through mid-2011 as hopes were high that the worst of the eurozone crisis was behind us. That certainly has not been the case, but the relationship could come back again if real progress is made in Europe that does not involve the exit of weaker nations such as Greece and Spain from the euro.
The relationship between the euro and stock market is important, but not always constant. Investors and traders should be aware that a weaker euro is not always bad for stocks and a stronger euro is not always good for stocks.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.