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Lower U.S. Dollar Boosts U.S. Stocks

Although the correlation between the stock market and the U.S. dollar does not in general imply any causation, with high certainty we can say that year-to-date stock index returns are for the most part related to currency fluctuations.

The U.S dollar index is losing about 9.5% of its value in relation to a basket of currencies year-to-date mainly due to persistent efforts by the new administrator to weaken it, even from the president himself, which is as unusual as it may sound.

In my opinion, this “devaluation” effort is due to the fact that the administration knows that no policies will have a positive short-term market impact and a falling dollar can make up for that in the usual sense, i.e., by boosting multinationals earnings and forcing a revaluation of equities.

But there is no free lunch in economics and finance.  A falling dollar spooks international investors who are either not sophisticated enough to hedge currency fluctuations or do not want to pay the premium for that. The result of this we have already seen with sharp rises in European (EZU) and Emerging markets (EEM) to the tune of 23% and 28% year-to-date, respectively. The S&P 500 total return (SPY) is about 10.5% year-to-date. At the same time, the U.S. dollar index (UUP) has dropped about 9.5%. It is highly probable then that for this year at least, the drop in the U.S. dollar has provided a cushion to U.S. equities, as shown in the chart below:

It may be seen from the above chart that the rise in S&P 500 total return (SPY) is nearly equal to the drop in Dollar Index (UUP). Is this a coincidence? Although this inverse relationship is not always true, in this case and in the given context, in my opinion it is not a coincidence. At the same time, the administration is boasting about higher stock prices assuming that the majority of those who live on local currency will not realize the trick. Note that this trick has been played in the past by several other administrations and it is not new at all, neither an invention of the current one. It is just a tested strategy that works in the short-term.

The negative effects of this policy will impact the consumer in a few months, when imported inflation will start rising. At the same time, the central bank will probably view this rise in inflation as an opportunity to raise interest rates. At the end of the day, the consumer will pay for these wrong policies, there is no free lunch. As far as the administration, they should know better when playing with a boomerang.

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Charting and backtesting program: Amibroker

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