The Correlation of Movements in the U.S. Dollar and Equity Markets

On July 14, the Federal Reserve released the Federal Open Market Committee Minutes from their last meeting in late June. The Minutes revealed the Fed has downgraded growth prospects for 2010; this is the first time the Committee has cut growth prospects since the economy rebounded in early 2009. There is also quite a bit of concern in China at the moment, as it is now evident their red-hot economy is beginning to slow down. They enacted measures in the last few months to tighten monetary policy, and these effects are now being felt. Also, the sovereign debt concerns in Europe have subsided at the moment, but the underlying issues are still very much present.

These three concerns—a slowing U.S. economy, a slowing Chinese economy, and sovereign debt problems in the EuroZone—are combining to fuel an attitude of soured investor sentiment, both globally and among U.S. stock traders.

The question is, have we only hit a bump in the road, or are we in for an extended period of lagging growth? The equity markets rallied quite nicely early in the week of July 12th, as corporate earnings reports came out quite positive. Alcoa and Intel led the charge as they crushed market expectations and a nice equity rally followed. However, the further development of concerns in China and poor economic data coming out of the U.S. is causing equity markets traders to stall at the moment. What’s interesting is that the rather dovish FOMC report did not cause an equity market sell-off. Instead, the markets closed the day at even. This seems to communicate that buyers want to push the market higher more than sellers want to push it lower. A poor retail sales figure and the negative FOMC report would have been enough to send the market tumbling if investors were simply waiting for a reason to sell.

However, that was not the case. In fact, it appears that market participants are simply waiting for a reason to buy. On July 14th, the Eurozone posted a very successful bond auction as struggling EuroZone countries including Spain and Portugal, were able to raise several billion euros in capital markets, and this was directly on the heels of a very positive bond auction in Greece a few days ago. This should serve to further bolster investor confidence in the EuroZone, as it appears the sovereign default threats are under control at the moment. So, we have a mixture of good and bad news that equity market participants are having to weigh.

Corporate earnings that are still coming out this week need to post positive numbers in order to further increase investor sentiment and cause a further rally in the equity market. It will be interesting to see how the U.S. Equity markets price in a slowing Chinese economy. Of course, equity market values are based upon the growth and contraction of U.S. companies, and U.S. companies are largely dependent upon relations with China. If China begins to slow significantly in the coming weeks, this could weigh heavily on U.S. equity markets.

An interesting correlation that has existed during the last 2 years in financial markets has been between equity markets and the FX Market. Typically, as equity markets have rallied, the U.S. Dollar has fallen. Likewise, as equity markets have fallen, the U.S. Dollar has risen. This is due to the risk aversion play. As equity markets fall and fear grips financial markets, a flight-to-quality move has caused investors to park their cash in U.S.-denominated debt, particularly T-Bills, which causes an inevitable rise in the U.S. Dollar. And then, when markets rally, investors take that money out of the low-yielding dollar and put it into higher yielding assets, since the current short-term interest rate target set by the Federal Reserve is basically 0%.

However, this rather predictable correlation has faltered lately. As equity markets have hit a bit of resistance in early July, high yielding risk currencies have outperformed significantly, as the Euro, Pound, and Aussie have dramatically risen to new highs. Thus, as the stock market has struggled, the U.S. Dollar has been plummeting. The question to consider now, is are we simply seeing a short-term breakdown of this correlation, or is the U.S. Dollar really going to be sold even in times of economic distress?

If the U.S. Dollar is sold in the Forex market as U.S. News comes out bad and equity markets fall, it could spell ultimate disaster for the Dollar. Due to wide yield spreads, the Dollar will definitely not rally during times of strong risk appetite. If it won’t rally during times of risk aversion either, we could be in the beginning stages of a dramatic bear run on the U.S. Dollar.