The S&P, U.S. Dollar And The Fed

Includes: SPY, UDN, UUP
by: Mark Vierra

There have been many questions about the relationship between the S&P and the US Dollar (USD).

In the not so distant past, having a strong currency would gain the respect and admiration of other countries, but those days are long gone. Today a weak dollar is seen as good and stock markets rally on dollar weakness.

The Federal Reserve (Fed) is "dovish", "risk" is erratically jumping between on and off and the S&P still maintains an "inverse" relationship to the USD. In this article I will explain what this means and some of the complex dynamics of the USD and the stock market. I will explain how the Fed affects these relationships in simple, easy to understand terms.

First, let's define terms as related to this subject.

Safe haven or risk off asset.

An investment made in times of world stress, conflict or turmoil. While most other investments in this market climate are considered risky, liquidity flow from these risk on assets to more historically safer areas. USD and US Treasuries are the best examples.

Inverse correlation.

An inverse correlation is any stock product, commodity or currency where the price moves directly opposite to each other. For example:

When the S&P goes up, the USD goes down.

When the USD goes up stocks go down.

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Hawkish or Dovish

Hawkish or dovish refers to statements used from central banks when describing their current sentiment on inflation and would indicate a possible change in interest rates. Hawkish for higher rates and dovish for lower rates. The entomology behind the term comes from the predatory, high flying hawk as opposed to the docile dove.

If inflation rears its ugly head the Fed becomes hawkish and counters with raising rates and enacting more restrictive credit policies. This in turn drives up the value of the dollar with higher overnight lending rates. Better interest rates makes the USD more attractive for investors to park money. The opposite of this is when the Fed doves take the position that inflationary pressures are low enough for low interest rates to be desirable.

How does this relate to the stock market?

There are two main factors behind the stock market dynamics in the USD:

  1. The risk off or safe haven status of an asset
  2. The perceived value of US currency strength against a basket of main currencies, reflected in the US Dollar Index (DXY)

For the first item and as stated before, as liquidity moves from one it often finds itself in the other (risk on/off). In other words, let's say there is "saber rattling" news from the Middle East. The US safe haven dollar moves up in value and stocks drop. Why? Some might say that oil will be more expensive and hurt corporations' bottom line. That may be true, however it is the more expensive dollar that is affecting stocks by a larger degree. Not only due to the greater demand for safety, but for the second factor of perceived dollar value, given above.

The perceived dollar value aspect is a bit more complicated with respect to how a lower USD affects a higher stock price, and a higher dollar drives stock prices down. If the value of the USD drops then goods and services will often adjust their price to compensate (i.e. it will be worth more dollars, but the intrinsic value remains the same). This continues from the largest corporations all the way down to the groceries of a common person. If the same companies in the S&P have not changed fundamentally - only the US currency has changed - then stocks adjust price to compensate for this change in value.

I do not necessarily agree with his grim outlook however I do like the way Gerald Celente put it:

Gold is not up, the dollar is down.

Stocks are not up the dollar is down.

For an average person this can be seen from a dramatically increasing grocery bill over the past several years. An inflation in commodities when rates are near zero and a history that will record the last 3 years as zero inflation.

To add further complication, it happens that there is a chicken or the egg scenario.

The same fundamental news changes the value of the USD and stocks simultaneously. Most of the time what is perceived as positive, and would indicate a stronger economy, is good for the USD as well as stocks. For a hypothetical example:

Better than expected gross domestic product (GDP) numbers come out and stocks rise.

But what happens to the USD? One would think that it should rise as well and sometimes it does. However in most cases it would remain flat or go down.

A dual aspect that adds yet another complication is the USD strength derived as a default safe haven currency.

GDP is good for the economy as well as the dollar, however the flow of liquidity in the markets would move away from the safe haven USD/Treasury or risk off assets. Demand would actually decrease and the USD would either remain flat or drop on the good news.

Demand for safety trumps the positive news.

Today's market environment has lost the counter effect of inflation fighting higher rates to go along with a higher GDP. Why? The biggest example of this, and the topic of many traders' minds, is the Fed. Keeping a low interest rate for an extended period, quantitative easing (QE) and the seemingly dedication to the devaluation of the USD, make the USD less attractive.

If you change the value of the dollar then the value of everything must give to the Yang of the dollar Yin.

As the Fed intervene, they have everything across the board going up in price from commodities (look at the price increase of the aforementioned grocery example) to stocks. Overnight and benchmark lending rates are kept at near zero and the recorded past 3 year history has inflation at near zero. The drop in the US Dollar value makes it no real wonder as to why groceries, commodities, stocks and gold are up in price.

The Fed affects the value of the dollar and thereby affects everything including the markets.

In basic economics we are taught that if you issue more shares in stock, this dilutes shares and drives the individual stock value down (assuming no increased demand). In this way, as the US Treasury issues more bonds and the Fed increases its balance sheet, intervention drives the value of the USD down. I do not want to digress too far on the import/export aspect of dollar value fluctuations, but on a broad scope a lower dollar means less imports, where US exports are more attractive. The trickle down from this is that when other countries suffer from exporting less, due to the lower valued USD, the chain reaction is they have less profit in turn to buy from the US.

How does understanding these things help?

I have created a spreadsheet to help me understand and track the USD value effect on the S&P. I multiply the value of the US Dollar index times the value of the S&P index (SPX), the product of which is an Adjusted, or "Normalized", version of the S&P. This removes the Dollar value fluctuation from the S&P. When analyzing this, it gives visibility to various clues in the market's risk on/off sentiment, and from the divergence away from any one-to-one, exact inverse relationship. The divergence reflects a unique view into not only risk, but the actual value sentiment of current market environment. In other words, if the normalized counterpart in the spreadsheet has higher value, I can not only say that short term sentiment is favoring more risk appetite, but more importantly, I can see how much of a degree of fluctuation between the S&P and the normalized version exists.

Although my belief is that it has promise, I take no responsibility to its validity. I think there is something here, but I am not sure that the weighting (equal in this case for each index) is valid. For example, should I have used a fraction the DYX value with the full value of S&P or vice-versa? There is no way to be sure without some sort of correlation analysis. It will take some time for the market to run through more bullish/bearish cycles to derive anything close to resembling conclusive.

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To conclude

The current perception behind the dollar/stocks inverse relationship seems wrong to most people, and think it should be the other way around. A stronger dollar should mean a stronger economy. Higher rates to fight inflation would mean a stronger economy and be a good thing. I think it's important not to over-emphasize the barrage of speculation (i.e. if the stock market goes up on bad news anticipating more QE stimulus or good news is bad for the stock market). In a constantly evolving market, we will see these correlations change dramatically over time. The day may soon come when the Fed becomes more hawkish, Treasury demand eases and stocks move more on their own merit, without the same influences of the US Dollar and risk on/off aspect. Many groups including the Chinese and especially the Russians have been calling for the demise of the USD default status for decades, but I don't think it'll happen. At least not in my lifetime.

The basic concepts of stock trading have not changed. The fluctuations of dollar value are just that. Fluctuations. My primary goal here is to provide some insight and answers to some perplexing questions, and break down some of the esoteric nature of common market discussions involving this subject.

Disclosure: I am long UPRO, AAPL, T, FCX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.