Blog - Investing Notes
October 24, 2008 - Update: The Dollar-Euro Exchange Rate and U.S. Stocks
Whenever a trend in the dollar-euro exchange rate develops, the experts start theorizing. A weak dollar is good because U.S. exports boom and domestic employment rises. Or, a weak dollar is bad because capital flees the U.S., and import prices spur inflation. What does the state of the dollar, as indicated by the dollar-euro exchange rate, mean for U.S. stocks? "Theories" collide, so perhaps empirical data can enlighten. In this entry, we examine the relationship between the dollar-euro exchange rate and the behavior of the U.S. stock market over the short and intermediate terms. Specifically, using historical data from 5/1/02-10/22/08, we relate recent trends in the exchange rate to returns for the S&P 500 index over the next 5, 21 and 63 trading days. We find that:
The following chart shows that the dollar has generally weakened (the number of dollars per euro risen) over most of the history of the euro. Visual inspection suggests that U.S. stocks prefer a rising dollar-euro exchange rate (weakening dollar) over the long term. However, the euro is young in terms of economic cycles, so interpretation of this visual impression is dubious.
For statistical analysis, we relate past changes in the dollar-euro exchange rate to future changes in the S&P 500 index.
The following scatter plot relates changes in the dollar-euro exchange rate over the past five trading days to S&P 500 index returns over the next five trading days. To ensure independence of data points, we sample every fifth trading day (324 observations). The Pearson correlation is 0.09. The R-squared statistic is 0.01, indicating that variation in the dollar-euro exchange rate last week explains only 1% of the variation in the S&P 500 index next week. Excluding the one outlying data point at the lower left makes the R-squared statistic 0.00, indicating no relationship and no trading edge.
Might extreme changes in the dollar-euro exchange rate be predictive for weekly stock returns?
The next chart recasts the data in the prior one by ordering five-day changes in the dollar-euro exchange rate from most negative (dollar strengthening) to most positive (dollar weakening). The horizontal axis is not time-sequential. There are no ranges of dollar strengthening or weakening that appear reliably predictive for five-day U.S. stock returns, although the most extreme drop in U.S. stocks follows an extreme strengthening of the dollar relative to the euro.
Might changes in the dollar-euro relationship be more telling over periods of a month than a week?
The next scatter plot relates changes in the dollar-euro exchange rate over the past 21 trading days to S&P 500 index returns over the next 21 trading days. To ensure independence of data points, we sample every 21st trading day (only 76 observations). The Pearson correlation is 0.13. The R-squared statistic is just 0.02, indicating that variations in the dollar-euro exchange rate last month explain only 2% of stock returns next month. Excluding the outlying data point at the lower left makes the R-squared statistic 0.00 (with a slightly negative Pearson correlation), again indicating no relationship and no trading edge.
Might extreme changes in the dollar-euro exchange rate be predictive for monthly stock returns?
The next chart recasts the data in the prior one by ordering the 21-day changes in the dollar-euro exchange rate from most negative (dollar strengthening) to most positive (dollar weakening). Again, the horizontal axis is not time-sequential. There are no ranges of dollar strengthening or weakening that appear reliably predictive for monthly U.S. stock returns, although the most extreme drop in U.S. stocks follows an extreme strengthening of the dollar relative to the euro.
Might changes in the dollar-euro relationship be more telling over periods of one quarter?
The next scatter plot relates changes in the dollar-euro exchange rate over the past 63 trading days to S&P 500 index returns over the next 63 trading days. To ensure independence of data points, we sample every 63rd trading day (just 24 observations). The Pearson correlation is -0.17, suggesting a very weak tendency for stocks to rise (fall) after the dollar strengthens (weakens) with respect to the euro. In other words, a strengthening dollar is slightly good for stocks. However, the R-squared statistic is just 0.04, indicating that variations in the dollar-euro exchange rate last quarter explain only 4% of stock returns next quarter. Moreover, the sample is very small. Neither the statistics nor the sample size support using the quarterly change in the exchange rate as a useful signal for quarterly stock trading.
Might extreme changes in the dollar-euro exchange rate be predictive for quarterly stock returns?
The final chart recasts the data in the prior one by ordering the 63-day changes in the dollar-euro exchange rate from most negative (dollar strengthening) to most positive (dollar weakening). Again, the horizontal axis is not time-sequential. There are no ranges of dollar strengthening or weakening that appear promising as reliable indicators for future quarterly U.S. stock returns.
In summary, recent trends in the dollar-euro exchange rate appear not to be useful short-term or intermediate-term trading signals for U.S. stocks.
See Blog Synthesis: The Economy and the Stock Market for analyses of the relationships between other economic indicators and stock returns.
