Asaf did a bit of a ranting in his recent Are you listening to the "Experts" post. That's encouraged me to get something off my own chest as well, something along the same lines.
You see, I spend my day watching the markets and listening to the folks on CNBC trying to explain what's driving the markets. I use the term "trying" intentionally because they certainly aren't getting it right in many cases. The one I keep hearing is that the movement in the dollar is driving the action in the stock market. Stocks rally on a weak dollar. Stocks fall on a strong dollar. Give me a break!
Let's first take a look at the rolling 1 month correlation between the stock market and the dollar. The chart below compares the performance of the S&P 500 to that of EUR/USD over the last year.
First thing to notice is that the two markets have swung back and forth between being highly positively correlated (stocks and dollar moving in opposite directions) and pretty negatively correlated (stocks and dollar moving in the same direction) several times. Moreover, in 2010 they haven't held correlations on either side of the range for very long before swinging back in the other direction.
More importantly, though, correlation does not mean causation. Just because US stocks and the dollar are going in opposite direction, as has been harped on so many times in the media, it doesn't mean one is causing the other. It more likely means they are both reacting to the same underlying factors.
The Same Driver, Different Actions
Think about the stock/dollar relationship. What would cause stocks and the dollar to move at the same time? That would be money moving into the dollar from abroad and being invested in the stock market, or the reversal of that process. In either case stocks and the dollar move in the same direction.
Now why would stocks and the dollar move independently? Stocks could move because of action involving money already in dollars – US data, earnings releases, interest rate expectations, etc. The dollar could move because of money being exchanged for trade purposes or investment activity outside stocks (Treasuries, real estate, etc.).
So what have we been seeing in the markets over the last year or so? We've seen risk aversion trading in some cases. That's when money piles into the USD as a safe haven. It doesn't go in to stocks. It goes into Treasuries. At the same time, nervous investors already in dollars are taking money out of stocks and putting them in to safer investments. So what we have is one motivating factor (risk aversion) causing stocks to fall and the dollar to rise basically independent of each other, but in a correlated fashion.
We've also seen the QE trade in the dollar. That's where folks move money out of the dollar for fear that increased money supply via the Fed printing money to purchase securities will lower the greenback's value and lead to inflation. It's simple supply/demand analysis. When you increase the supply of something you decrease its value. QE is seen as increasing the supply of dollars, so the USD's value drops. The QE trade causes money to flow out of the dollar, which means foreign flows (on net) cannot be moving into stocks, so we have no dollar-related reason for stocks to rise. They are moving for their own reasons (better earnings prospects, lower interest rates, etc.), but again, linked to a similar underlying driver.
Follow the Money
My point is this: think these things through. If you are looking at the markets from a fundamental point of view you need to think in terms of the flow of money. Investment flows are a big driver, so you have to understand the implications of different events and development in those terms to really understand what's underpinning the market's action. Follow the money. It's a simple thing folks on CNBC don't seem to be able to do.
Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results.