Data compares the dollar to the Dow Industrials from 1985 through the third quarter of 1989. For the first two years stocks rose sharply as the dollar dropped. From 1988 through the middle of 1989, stocks and the dollar rose together. So what does the chart demonstrate? It shows that sometimes the dollar and stocks move in the opposite direction and sometimes in the same direction. The trick is in understanding the lead and lag times that usually occur and also the sequence of events that affect the two markets.
Data shows the dollar dropping from 1985 through 1987, during which time stocks continued to advance. Stocks didn't actually sell off sharply until the second half of 1987, more than two years after the dollar peaked. Going back to the beginning of the decade, the dollar bottomed in 1980, two years before the 1982 bottom in stocks. In 1988 and 1989 the dollar and stocks rose pretty much in tandem. The peak in the dollar in the summer of 1989, however, gave warnings that a potentially bearish scenario might be developing for the stock market.
It's not possible to discuss the relationship between the dollar and stocks without mentioning inflation (represented by commodity prices) and interest rates (represented by bonds). The dollar has an impact on the stock market, but only after a ripple effect that flows through the other two sectors. In other words, a falling dollar becomes bearish for stocks only after commodity prices and interest rates start to rise.
Until that happens, it is possible to have a falling dollar along with a rising stock market (such as the period from 1985 to 1987). A rising dollar becomes bullish for stocks when commodity prices and interest rates start to decline (such as happened during 1980 and 1981). In the meantime, it is possible to have a strong dollar and a weak or flat stock market.
The peak in the dollar in the middle of 1989 led to a situation in which a weaker dollar and a strong stock market coexisted for the next several months. The potentially bearish impact of the weaker dollar would only take effect on stocks if and when commodity prices and interest rates would start to show signs of trending upward. The events of 1987 and early 1988 provide an example of how closely the dollar and stocks track each other during times of severe weakness in the equity sector.
Data compares the stock market to the dollar in the fall of 1987. Notice how closely the two markets tracked each other during the period from August to October of that year. As discussed earlier, interest rates had been rising for several months, pulling the dollar higher. Over the summer both the dollar and stocks began to weaken together. Both rallied briefly in October before collapsing in tandem. The sharp selloff in the dollar during the October collapse is explained by the relationship between stocks, interest rates, and the dollar. While the stock selloff gathered momentum, interest rates began to drop sharply as the Federal Reserve Board added reserves to the system to check the equity decline. A "flight to safety" into T-bills and bonds pushed prices sharply higher in those two markets, which pushed yields lower. As stock prices fall in such a scenario, the dollar drops primarily as a result of Federal Reserve easing. The dollar is dropping along with stocks but is really following short-term interest rates lower. Not surprisingly, after the financial markets stabilized in the fourth quarter of 1987, and short-term interest rates were allowed to trend higher once again, the dollar also stabilized and began to rally. Data shows the dollar and stocks rallying together through 1988 and most of 1989.
THE SEQUENCE OF THE DOLLAR, INTEREST RATES, AND STOCKS
The general sequence of events at market turns favors reversals in the dollar, bonds, and stocks in that order. The dollar will turn up first (as the result of rising interest rates). In time the rising dollar will push interest rates downward, and the bond market will rally. Stocks will turn up after bonds. After a period of falling interest rates (rising bond prices), the dollar will peak. After a while, the falling dollar will push interest rates higher, and the bond market will peak. Stocks usually peak after bonds.
This scenario generally takes place over several years. The lead times between the peaks and troughs in the three markets can often span several months to as long as two years. An understanding of this sequence explains why a falling dollar can coexist with a rising bond and stock market for a period of time. However, a falling dollar indicates that the clock has begun ticking on the bull markets in the other two sectors. Correspondingly, a bullish dollar is telling traders that it's only a matter of time before bonds and stocks follow along. Read More : The Dollar Versus Stock Market
