What is the correlation between American stock prices and the value of the U.S. dollar?

By Matt Lee AAA
A:

The correlation between any two variables (or sets of variables) summarizes a relationship, whether or not there is any real-world connection between the two variables. The correlation coefficient will always be between -1 and +1. These two extremes are considered perfect correlations. A negative coefficient means that the two variables, or sets of variables, will move in opposite directions (if one variable increases, the other will decrease); a positive coefficient will mean that the two will move in the same direction (as one increases, the other will increase).

If we compare the US Dollar Index (USDX), an index that tracks the value of the U.S. dollar against six other major currencies, and the value of the Dow Jones Industrial Average (DJIA), Nasdaq and S&P 500 over a 20-year period, the correlation coefficient calculated for the USDX versus the DJIA, Nasdaq and S&P 500, is 0.35, 0.39 and 0.38, respectively. Note that all of the coefficients are positive, which means that as the value of the U.S. dollar increases, so do the stock indexes, but only by a certain amount. Notice also that each coefficient is below 0.4, which means that only about 35% to 40% of the stock indexes' movements are associated with the movement of the U.S. dollar.

A country's currency can become more valuable in relation to the rest of the world in two main ways: when the amount of currency units available in the world market place is reduced (for example, when the Fed increases interest rates and causes a reduction in spending), or by an increase in the demand for that particular currency. The fact that an increase in the U.S. dollar affects the value of American stocks seems natural, as U.S. dollars are needed to purchase stocks.

The value of American stocks, especially those that are included in market indexes, tend to increase along with the demand for U.S. dollars - in other words, they are positively correlated. One possible explanation for this relationship is foreign investment. As more and more investors put their money in U.S. equities, they are required to first buy U.S. dollars, which can be used to purchase American stocks, causing the indexes to increase in value.

For more insight, see Commodity Prices And Currency Movements and Using Currency Correlations To Your Advantage.

RELATED FAQS

  1. What are the Basel III rules, and how does it impact my bank investments?

    Learn about Basel III rules and how they impact investors in the banking sector. They have made banks less procyclical, forcing ...
  2. How does the balance of trade impact currency exchange rates?

    Find out how the balance of trade affects a country's exchange rates and how those exchange rates can, in turn, affect the ...
  3. What advantages do corporations have over privately held companies?

    Learn about the chief advantages that publicly traded corporations have over other forms of business organizations, most ...
  4. Where did the term 'pip' in currency exchange come from?

    Learn the definition of a pip, what it means in the scope of currency exchanges and how to determine its value. Find out ...
RELATED TERMS
  1. Market Value

    The price an asset would fetch in the marketplace. Market value ...
  2. Bulldog Market

    A nickname for the foreign bond market of the United Kingdom. ...
  3. ICE LIBOR

    See LIBOR
  4. WM/Reuters Benchmark Rates

    Spot and forward foreign exchange rates that are used as standard ...
  5. Float Shrink

    A reduction in the number of a publicly traded company’s shares ...
  6. Capital Strike

    A refusal of businesses to invest in a particular sector of the ...

You May Also Like

Related Articles
  1. Forex

    The Top 10 Forex Brokers Regulated In ...

  2. Forex

    Top Investments for a Strong U.S. Dollar

  3. Fundamental Analysis

    What are some examples of Cash Flow ...

  4. Economics

    Who Benefits From South Korea's Lowered ...

  5. Mutual Funds & ETFs

    Which ETF is the Best Bet: VTI or IWV?

Trading Center