Market Extra: What a rampaging dollar means for stocks

NEW YORK (MarketWatch) —The greenback did its best Incredible Hulk imitation in the first three months of 2015, with the ICE U.S. dollar index smashing the way to its best quarterly performance since 2008 as currency volatility created turmoil throughout financial markets.

2015’s volatile first quarter explained in 7 charts

So it is no surprise investors are keeping a close eye on the dollar at the start of the second quarter. Here’s what you need to know about the dollar:

It isn’t as strong as you think

The broad index is still below its long-run average.

The strength of the ICE dollar index DXY, -0.16% which rose 9% in the first quarter, is impressive, but it might also be a bit misleading. The index isn’t trade-weighted and the euro EURUSD, +0.21%  , which dropped more than 11% in the first quarter, has an outsize influence.

The chart above from Capital Economics shows the Federal Reserve’s real trade-weighted index, which measures the dollar’s value against a large number of trading partners after adjusting for relative rates of inflation and the amount of trade between the partners and the U.S. On this basis, the dollar’s value has merely returned to close to its long-run average, explained John Higgins, market economist at Capital Economics.

No long-term correlation

Over the long run, the correlation between U.S. stocks and the dollar is near zero. In other words, their movements have little to do with each other. In the short run, however, periods of dollar strength have correlated with equity gains and equity weakness, as the chart above from Forex.com illustrates.

As the dollar climbed in the first quarter, stocks fluctuated in often volatile trade, but the benchmark S&P 500 SPX, -0.40%  ended the first three months of the year modestly higher than where it ended 2014.

Matt Weller, senior technical analyst at Forex.com, found that the 21-day (one-month) correlation between the U.S. dollar and U.S. equities is currently minus 0.54, which means that over March equities and the dollar tended to move in opposite directions. The correlation, however, had been positive at the beginning of the month, meaning the dollar and equities tended to move in the same direction.

Dollar Index

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