Factors behind the positive dollar/stock relationship from the late 1990s are no longer in place.
I n level terms, the rolling 26-week correlation between the trade-weighted dollar and U.S. equities is about to turn positive. But this is nothing out of the ordinary as it occurred for brief periods in the past and none of those previous episodes marked a structural return to a positive relationship. Our Foreign Exchange Strategy service argues that the fundamental factors that drove the dollar/stock relationship in the late 1990s are not in place today. A key reason for the positive correlation in the 1990s was the growing importance of foreign equity inflows, which tend to be unhedged.
Currently, government fixed income instruments account for the vast majority of capital flows into the U.S., and these flows are more likely to be hedged. If the U.S. current account deficit continues to reflect the large fiscal deficits, then foreign capital inflows must be largely into government fixed income securities, not into U.S. equities. This will make it difficult for a positive dollar/equity correlation to reassert itself. Also, in the 1990s, “risk on” meant buying U.S. tech stocks and therefore the dollar.
Today, the risky assets that investors want are outside of the U.S., particularly in emerging markets. So, when markets have a “risk on” bias, private capital leaves the relative safety of U.S. government securities for risky assets elsewhere; consequently, the dollar comes under pressure.
Bottom line: Over the last few weeks, both U.S. stocks and the dollar have managed to strengthen. We doubt that this is the start of a long term positive correlation like that seen in the late 1990s.