How does the dollar influence equities?

If you want to work out how equities are going to perform during various market conditions, particularly our current abnormal times, it is worth closely monitoring the ups and downs of forex (foreign exchange markets).

“You'll find a lot of currency traders, even say bigger equity traders, they all look at the dollar,” Patrick Reid, co-founder of The Adamis Principle, a market education and mentoring platform for Forex trader, says. “If you’re doing any kind of size you need to have an eye on everything … I mean Forex is my game, but I look at all assets.”

When using a daily timeframe, Reid looks at what the dollar is doing. But when trading equities, he looks at sentiment and the reasons behind a rally or sell-off. He goes on to explain that if the dollar is weak then it’s best to take a risk on approach.

“I feel that this turn in the dollar is real for a lot of other reasons, which will be supportive of equities. If you put that within the context of buying equities then it's an extra confirmation for me,” he adds.

 

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King of the currency world

There is a good reason for such a strong correlation, and it is no coincidence. The US dollar is the world’s funding currency after all.

“It’s a reserve and what that means is that every country in the world needs to have a certain amount of dollars that it can draw on to pay for stuff,” Reid explains. “If the dollar goes higher that means that it is more expensive to pay for the debt in dollar, for example. So when things are more expensive in dollars you tighten your belt as a country and as an investor,” he states.

Reid notes that when the dollar is up, then in order to avoid getting caught short you might want to sell. Equities are one of the highest-risk assets an investor can own, he says.

“When all things are good, [the S&P 500 and DJIA] go higher because people want to buy that risk. But when the dollar goes higher, the opposite happens.” As Reid emphasises, it’s not always simple and mistakes can be made when following currency moves.

“When all things are good, [the S&P 500 and DJIA] go higher because people want to buy that risk. But when the dollar goes higher, the opposite happens”

 

Foreign currencies drive strength in the dollar

While Reid does look at the US Dollar Index [DXY], which is the measure of the value of the dollar relative to a basket of foreign currencies, he also focusses on euro.

“If the euro aspect of the index is the mover then the dollar index has to be taken with a pinch of salt because that’s not actual real dollar strength,” he explains.

He uses the example of ECB president Christine Lagarde cutting back on quantitative easing for example, which could lift the euro dollar. “But you could get a lot of pain from that because it’s the euro being strong not the dollar.”

Reid stresses that if traders want to get a real gauge on risk then they could look at how the dollar trades against emerging markets currencies such as the rand and the rouble.

“When dollars go lower in emerging markets then it is risk on. I’m bearish on the dollar but bullish on equities,” he states.

“When dollars go lower in emerging markets then it is risk on. I’m bearish on the dollar but bullish on equities”

 

“The dollar yen is also a great tool for equities, as the yen doesn’t move at all. It tracks a positive correlation with the Dow Jones and also S&P Futures. Use that with another asset such as 10-year US Treasury yield and you have got something quite potent.”

 

Is a softer dollar a bullish signal?

While the US dollar has certainly been devalued in recent weeks due to increased borrowing and spending, Reid says that this move has generally been positive for equities.

“They are rallying at the moment and the dollar being softer is a very good reason to support that. If you put that within the context of buying equities then it is an extra confirmation for me,” he says.

“They are rallying at the moment and the dollar being softer is a very good reason to support that. If you put that within the context of buying equities then it is an extra confirmation for me”

 

However, investors should not expect stock markets to soar and reach new highs in the present climate, with Reid calling it a bear market squeeze. “A weaker dollar does support stocks, but we are not going to be entering new highs.”

 

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