The Dollar Isn’t That Mighty

Is the dollar pushing the stock market around? Many think so, with some pointing out last year’s strong dollar coinciding with weak stocks—and vice versa this year. They see the dollar’s moves as causal—and new. But in our view, this purported power of the US dollar is misplaced and the misperception is old. The greenback’s relative strength or weakness doesn’t drive stocks’ direction.

Now, stocks’ struggles last year did coincide with a strong dollar, and many attributed the latter to Fed rate hikes. The rationale is logical: All else equal, money flows to the highest yielding asset, so the Fed—which out-hiked other major central banks last year—likely contributed to an extent to a stronger dollar. From January to mid-October, the dollar rose 11.0% against a trade-weighted basket of currencies while the S&P 500 endured a bear market, falling -24.5% over the same stretch.^[i] Moreover, US stocks’ rebound (7.8%) for the rest of the year coincided with the dollar falling -5.2%, and that has continued in 2023. Year to date, the S&P 500 is up 15.2% and the dollar is down -2.1% against other major currencies.^[ii] Based on this, some think currency fluctuations will dictate stocks’ fate going forward.  

We agree the dollar and stocks have an interesting relationship, but it isn’t that the former drives the latter. As we discussed last month, when stocks fall, investors tend to seek stability (i.e., what some call a flight to quality). The dollar fills this role well thanks to its deep, liquid capital markets, and in our view, investors sought this sanctuary during last year’s bear market. Moreover, when a downturn ends and stocks recover, the dollar tends to weaken—as it has since October last year, which has aligned with stocks’ rebound. This isn’t a causal relationship, though, in our view—it is coincident, based on sharp sentiment swings around inflection points, which is largely what seems to drive the moves in both assets.

Consider: If a strong dollar was inherently bad for stocks, history should confirm as much away from troughs and early recoveries. But the past paints a more nuanced picture. During the 1990s bull market—a terrific time to own stocks—the dollar rose 33.9% from April 1995 – August 1998.^[iii] The greenback also got buff for a good chunk of the 1982 – 1987 bull market, strengthening relative to other major currencies from January 1982 – September 1985.^[iv]

Likewise, there have been stretches of a weakening dollar and falling stocks. From August 2007 – July 2008, the dollar fell -9.5% against a trade-weighted basket of currencies—and over that same period, the S&P 500 fell -12.3% (and entered the 2007 – 2009 bear market in October).^[v] Or go back to 2002: The dollar fell -6.1% from February’s end through mid-July as stocks plunged -23.2%.^[vi] The latter was mired in the throes of the 2000 – 2002 bear market, but the weak dollar didn’t jumpstart a recovery—stocks bottomed in October. 

In our view, currencies and stocks are similarly liquid markets and pre-price all widely known information close to instantaneously. Said another way: Currency traders don’t possess special insight over stock investors, and may actually be the same people in some cases. Rather, the asset classes have different demand drivers. We think stocks focus mostly on the probable economic and political conditions over the next 3 – 30 months and how they align with expectations. As we have written, sentiment played a huge role in last year’s bear market. Investors grappled with fear after fear, from elevated inflation and supply chain issues to energy shortages and recession projections. In our view, the strong dollar resulted partly from that prevalent pessimism, fueling false fears of its impact moving forward. But treating coincidence as causality is an investing error as old as the hills, and we think conflating currency swings as a stock market driver is just that.