There’s a growing disconnect.
Since the April lows, the S&P 500 has gained 18%. It’s only 4% below the prior record high set in February.
The rally started when President Trump announced a 90-day pause on his tariffs.
Then a trade war truce with China allowed more time for negotiations. Investors breathed a sigh of relief. They hoped that trade deals would be struck and contain the damage to the economy.
But one crucial market isn’t sending the same bullish message… currencies.
Since last year, the U.S. dollar has been rising and falling in near lockstep with the stock market.
But now it has stopped.
Today, let’s look at why the lagging dollar could pose a problem for investors…
The Dollar’s Relationship With Stocks
The U.S. Dollar Index (DXY) tracks a basket of major currencies compared to the dollar. That includes the euro, Japanese yen, and British pound.
When DXY moves higher, the dollar is strengthening against other currencies. When it falls, the dollar is weakening.
Over the past year, the S&P 500 and DXY have become very correlated. They tend to move in the same direction… higher or lower.
Take a look at the chart below:
You can see that DXY (black line) and the S&P 500 (blue line) peaked last summer at “1.” Then they dropped during last August’s sell-off in stocks around the world.
Both rallied following last November’s election. DXY peaked at “2” over a month before the S&P 500 did. But both plunged in early April due to uncertainty caused by tariffs and trade wars.
Following a pause on tariffs, the S&P 500 and DXY both found a bottom around the same time at “3.”
But look at what’s happened since then.
The S&P 500 has recovered almost entirely from its plunge. But DXY is still hovering near the lows.
The relationship between the dollar and the S&P 500 is breaking down.
And there’s good reason to keep a close eye on developments in the currency market…
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Why the Dollar Is Lagging
Investors should heed the currency market when warning signals appear.
After all, the global currency market is larger than both stocks and bonds. There is as much as $7.5 trillion in currency trades every day.
Many factors can strengthen or weaken the dollar relative to other currencies. Differences in interest rates play a key role, for example.
A country with higher rates can attract investor capital looking for better returns. That demand often strengthens currencies in countries with higher rates.
Right now, the U.S. has the highest short-term interest rates among developed countries… yet the dollar is still faltering.
Changes in the economic growth outlook can impact currencies too… as well as concerns over fiscal imbalances like too much government debt and deficit spending.
This time, these are the likely reasons DXY isn’t rallying alongside the S&P 500.
New trade war headlines pop up constantly. The current effective tariff rate still sits at 7.0%. That’s the highest since 1969.
Additionally, the trade war back and forth is creating uncertainty for consumers and businesses alike. That’s clouding the growth outlook.
At the same time, the U.S. is projected to keep running large fiscal deficits over the next decade. This year alone could top $1.9 trillion, which means the $36 trillion federal debt pile will keep growing.
While the S&P 500 is within reach of the prior highs, the lack of confirmation in the dollar shows that some key risk factors haven’t gone away.
And while the S&P has shaken off these potential problems for now, stocks could face growing challenges in the months ahead.
Now may be the perfect time to play it a little safe.
Happy Trading,
Larry Benedict
Editor, Trading With Larry Benedict
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