The Dollar And Equities Revisited

The divergence meme that had the US well ahead in the global business cycle produced a virtuous cycle. The dollar and US stocks rallied together. However, with the dollar’s appreciation spurring concern about US corporate earnings, and the negative interest rates in Europe spurring flows into equities, correlations between the dollar and equity markets has shifted again and that is one of the important themes here in Q1. 

The implication of these shifting correlation does not just important for hedging decisions, but also reflect changing drivers. First, the outperformance of US shares last year open a large divergence in valuation with European equities. This gap has been closed now, or nearly so.  Second, the sharp rise in the dollar hurt the translation of foreign sales into dollars for accounting purposes. Third, deflation and the ECB’s policy response has created a powerful incentive to move into European equities. A significant fraction of European bonds have negative yields. Foreign investors have been significant buyers of European equities. During some weeks, the flow of funds out of US equity funds into European equity funds matched up almost dollar for dollar. 

As investors, we are interested in the correlation of returns. This can be approximated by running the analysis on the basis of percentage change. This is more robust that monitoring levels and cannot simply be eyeballed. We look at the 60 and 90 day correlations.    

From last October through earlier this month, the 60 and 90-day correlation between the S&P 500 and the euro were inversely correlated. That is to say, the dollar’s pace of appreciation against the euro was correlated with the pace of the S&P gains.   

This  changed earlier this month. The euro and the S&P are now positively correlated (percentage change). The 90-day correlation stands at 0.1.  At the end of last year, it was at -0.32.  The 60-day correlation is at 0.35 compared with -0.34 at the end of 2014.