What Does The Recoupling Between The U.S. Dollar And The S&P 500 Tell Us?

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Includes: SPY, UDN, UUP
by: Evariste Lefeuvre

Before the Great Recession, there was no clear cut correlation between the USD and the S&P 500 daily returns whereas gold was negatively linked to the USD. This relationship held well past the 2008 meltdown while the DXY became negatively correlated to US stock markets (lower USD => higher US stocks).

Monetary policy is a potential driver of the correlation between stocks and the USD. For instance the correlation may turn negative or positive when the Fed tightens. Unfortunately, the chart below shows that the correlation can be negative when the Fed raises rates (2004/2006) but also when it cuts them (2001). This is because monetary policy responds either to growth (positive for stocks) or to inflation (less straightforward impact on valuations).

If we refer to periods when the Fed reacted to the inflation risk (acceleration of the CPI generally driven by higher oil prices - 1999 and 2004-06), the correlation between stocks and the DXY has been negative.

Therefore, in a "traditional" pattern of economic cycle and monetary policy:

  1. If oil prices remain muted (my scenario) while US inflation decelerates (see Bullard's remark on inflation that "surprised on the downside"); and
  2. If the Fed waits a long time before it raises Fed funds,

... then the correlation between stocks and the USD could remain positive for a while.

But the past may be misleading, and things are not as simple as that, since two factors have affected the traditional patterns over the last decade:

  1. The "assetification" of commodity prices; and
  2. The implementation of quantitative easing.

The result has been a growing concentration of risky asset returns (risk on/off). I called for a weakening of the risk on/off pattern as early as late last year, but the level of concentration remains above the average of the past two decades and global central banks have not drastically modified the implementation of asset purchases.

Is the upward trend in the correlation an early indicator of the tapering of the Fed? It is too early to tell, but tapering comes at a time when inflation is not accelerating, growth remains resilient as the recent NFP have shown, and US stocks remain relatively attractive against many other asset classes.

Tapering would reflect the relative strength of the U.S. economy and be completely consistent with higher stocks and a stronger USD.

And for those afraid of higher US Treasury yields hammering US stocks, there is a correlation that has not changed since 1998: stock returns are still positively related to changes in long bonds yields.

This explains why the sharp increase and the new sign of the dollar/stocks correlation might not necessarily be seen as an ominous signal.

After a few months when both the stock and gold correlation to USD faltered (close to zero), gold is correlated to the dollar once again. Stocks and the USD now have a slightly positively correlation: a return to the pre-crisis level?

The correlation between the USD and the S&P 500 has never been stable. Yet, the lengthy period of strongly negative correlation is clearly unusual, and the threshold breach must be explained. In particular, if the correlation is regime-dependent, then the drivers have to be identified.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.