James Pethokoukis

Politics and policy from inside Washington

The worrisome relationship between a strong stock market and a weak dollar

August 26, 2009

The dollar drops and stock rise. If the dollar is supposed to be a reflection of economic strength, this should tend not to happen.  David Goldman find this weird, too — and then explains it:

Something ominous is at work here. Typically, a stronger dollar goes together with a stronger stock market. That is what we observe prior to the bank bailout last fall. Starting in the third quarter of 2008 and going to the present, the correlation turns sharply and persistently negative. A cheaper dollar means higher stock prices, as US assets are marked down for global investors.

What we have is not a stock market rally but an adjustment to global market prices. Fully 80% of the movement in the S&P can be explained by the movement in the dollar index.

That is a profile well known to emerging market investors. Whenever the Brazilians would pull another currency devaluation, stock prices rose to compensate, as tradeable assets floated up to world market prices. The bank bailout has made Americans poorer relative to the rest of the world and created the illusion of a stock market recovery.

That does not necessarily mean that inflation will return to the US, as some analysts believe. Foreign investors are not likely to buy homes in Cleveland (although the dollar devaluation certainly should help real estate prices in New York or San Francisco). And the combination of high unemployment and deferred retirement (greeter jobs at Wal-Mart will be in great demand) will keep wages down. The price of international tradeables, though, will affect US inflation, which is why I continue to recommend classic commodity hedges (including gold and oil) rather than TIPS.

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