Dollar And Stocks: Shifting Correlations?

This Great Graphic depicts a shift in correlations between the euro-dollar exchange rate and the S&P 500.

The first chart is the results of a correlation conducted on the percentage change of the euro and the percentage change in the S&P 500 on a rolling 30-day basis. As investors, we are most interested in the correlation of returns.

While we prefer a 60 day rolling correlation, the market appears to have entered a new phase last month. We know that the reach for yield reversed in May and what was heralded as a "trade of the century" (short yen and long the Nikkei) was quite frustrating.

While recognizing that the correlation study could be more robust, it is suggesting a potential change in the relationship. As the chart shows, the correlation of the euro and S&P returns has broken down and is now inverse for the first time in several years. The 60-day correlation has not turned negative, but it has been trending lower and tested the lower end of where it has been since the crisis in late May, dipping below 0.25.

This second chart shows the results of a similar correlation exercise, but instead of the euro, we used the Dollar Index. There is a big overlap between the two because the composition of the Dollar Index is heavily weighted toward the euro and currencies that move in the euro's orbit, like the Swiss franc, British pound and Swedish krona. Together they make up 77.3% of the Dollar Index.

The remaining 22.7% consists of the yen and the Canadian dollar. It is not representative of US trade. Two of the US's largest trading partners, Mexico and China, are not even included. Nevertheless it is a popular reference point and speculative vehicle, with some ETFs, like PowerShares DB US Dollar Index Bullish Fund (UUP) and PowerShares DB US Dollar Index Bearish (UDN) (which together have about $800 mln market cap or AUM) based on it.

The correlation of the percent change in the Dollar Index and the percent change in the S&P 500 has swung positive for the first time in year on a 30-day rolling basis. Again this is preliminary and not confirmed (yet?) on a 60-day basis. The 60-day correlation is still inverse but near -0.12, which is the least inversion since the Lehman debacle.

We see this as a yellow flag: Be warned that a significant shift may be underway and that investors should monitor these developments closely in the period ahead.