One might consider how currencies add or subtract volatility from a market in any given part of the cycle. After all, currency does affect and change the fundamentals of many economic indicators. Interestingly enough though, historical data tells us that the US dollar and stock movements don’t actually have a strong correlation, positively or negatively. In fact, there is almost no meaningful pattern at all. Let’s look at some of the arguments of a strong dollar versus a weak dollar and effect each can have on the markets.
There is generally some fear around a ‘weak dollar’. After all the word ‘weakness’ in and of itself does have negative connotations. The logic behind the fear is that if the dollar is weak, consumer confidence will drop, slowing economic activity and hindering stock growth. Also, if the dollar is weak, investors may look elsewhere globally to invest. Couple that with more expensive import costs for companies and consumers requiring foreign goods and you can see a potential negative effect to the market. A strong US dollar on the other hand, can also be seen as negative. If the dollar is strong, our exports cost more for other countries to purchase. This can cause a decline in US companies’ exports, resulting in a decrease in earnings and reflected in their stock prices.
The market historically doesn’t have a clear preference on weak vs strong dollar in relation to its future returns. Also, it’s prudent to remember currencies are commodities, not appreciating assets like stocks. Currency weakness is only relative to the strength of other currencies and is cyclical in nature. If the dollar is weak, it’s because another currency is strong, and vice versa. There will always be times of weakness and times of strength, depending on perspective. This differs from stock prices, which in theory are based on a company’s fundamental worth determined by examining earnings, value, and growth potential.
DataTrek Research[i] performed a long-run correlation analysis between the dollar and the S&P 500. The study found a correlation of -0.26, indicating a moderately weak negative correlation between the two. As a reminder, the closer a correlation is to 0, the weaker it is, while the closer to +/- 1, the stronger it is. Also, the standard deviation (the amount of dispersion of a set of values) of this time series is .23, meaning we can expect S&P 500 stocks and the dollar to trade in a band of essentially 0 to -.5 correlation 84% of the time.
All this to say there are certain companies, asset classes, or sectors that can be affected by changes in the dollar, but broadly we can say there is not a strong correlation with the strength or weakness of the dollar and the market. In conclusion, making investment decisions solely based on dollar strength or weakness, whether it be current or forward-looking predictions, would not be recommended. Instead, use it as one of many tools in the toolbox. At Harbor, we certainly keep an eye on the dollar in relation to other currencies and use it in tandem with other economic data to help drive our investment decisions. We utilize currency hedging and non-USD denominated bond funds in order to gain currency exposure, providing a diversification benefit in times of currency fluctuation.
[i] DataTrek Research (10/18/2021). Dollar/Stock Correlations, S&P Margins. https://www.datatrekresearch.com/dollar-stock-correlations-sp-margins/