Comment 37: Dollar and stock prices (Nov. 30, 2006)

This website has been advocating the theme that trade deficits influence US economy, as discussed in articles 1, 2 and 2A. When trade deficits expand, US economy booms, and when trade deficits stagnate or shrink, US economy slows down or enters into a recession. US trade deficits are in turn affected by the movements of the exchange rates of US Dollar against the currencies of its major trading partners; the currency movements usually precede the ups and downs of trade deficits by two to three years. At the time when the sudden swing of US Dollar vs. Japanese Yen and Euro has caused substantial anxieties in US stock markets, readers are probably interested to know the relation between movements of US Dollar and stock prices. In this comment we will analyze the effect of Dollar movements on stock prices.

Stock markets are auction markets where buyers of stocks and sellers of stocks are always matched. When sellers of stocks become more aggressive than buyers of stocks, stock prices fall. When buyers become more aggressive, stock prices rise. Surrounding the stock markets there is a pool of liquidity readily available for investment and speculation. Buyers withdraw money from the pool to purchase stocks and sellers deposit the sale proceeds back into the pool. In short-term the size of the pool stays more or less constant even stock markets experience large gyrations. However, when stock prices fall, the total capitalization of stocks shrink compared to the size of the pool of liquidity. This creates an "oversold" condition from which more likely stock prices will bounce back. If stock prices rise, the opposite "overbought" condition will develop. The long-term direction of stocks in general will be influenced by the changing size of the liquidity pool. Many factors will shape the size of the liquidity pool. One obvious factor is the monetary policy of The Federal Reserve Board (FED). When FED drains liquidities from the financial system, the liquidity pool for investment and speculation usually shrinks, when FED loosens the monetary condition, the liquidity pool tends to expand. Another not well appreciated factor is the run away trade deficit. When US runs trade deficits, the dollars from the pockets of US consumers flow into the hands of foreign exporters. Since US Dollar is not legal tenders in foreign lands, foreign exporters must sell those dollars at hand to someone and eventually those trade-deficit generated dollars must be reinvested back into US market. The crucial thing to notice is that when those trade-deficit generated dollars come back to US, they are in the hands of large foreign institutions, including foreign governments that collects dollars through currency market intervention to keep their currency undervalued so that they can continue to export to US. Those foreign institutions are not going to use those trade-deficit generated dollars to buy daily usage items in US market, but will put them into the investment and speculation pool. This flow of dollars should be compared to the case that the original dollars from consumers are handed over to domestic producers instead. Domestic producers will use the dollars they receive to pay their workers and suppliers, and those who received the dollars just spend in the normal way. In other words those dollars paid to domestic producers will just go through the normal route through the whole economic system, and only a fraction of the original dollars will trickle down into the liquidity pool of investment and speculation. Thus we can see that trade deficits become a super efficient tool to convert consumption dollars into the liquidity for investment and speculation. As US trade deficit increases to around 6% of the total GDP, the effect on stock prices can be overwhelming. That is the reason why when US trade deficit expands strongly, stock prices receive a strong support, but when trade deficits shrink, stock prices dive in the globalization era during which US trade deficit has jumped drastically.

Currency market is also an auction market in which buyers and sellers are always matched. When sellers become more aggressive than buyers, Dollar will fall, and when buyers become more aggressive, Dollar will rise. Beyond the auction markets of currencies, we can imagine that there is a pool of dollars ready to be sold for foreign currencies, and there are also similar pools of foreign currencies ready to enter currency markets to buy dollars. When dollars are sold, the buyers simply return the received dollars back into the pool, so in short-term the overall amount of dollars in the pool does not change even the exchange rates of Dollar moves violently. The long-term direction of Dollar is influenced by the change of the size of the pool of dollar compared to the corresponding pools of foreign currencies. The sizes of the pools of Dollar and foreign currencies are determined by many factors. The sizes are influenced by the monetary policies of various central banks, including FED. The pools are also affected by the currency market intervention of foreign governments that tends to expand the sizes of the pools of corresponding foreign currencies. Trade deficits are also a factor that will increase the size of the dollar pool.

A monetary action of FED can serve as a common factor that will move the sizes of both the liquidity pool for investment and the dollar pool surrounding the currency markets. If FED tightens the monetary condition, the size of liquidity pool for investment and the size of dollar pool to buy foreign currencies will both decrease. As the result stock prices will fall and the value of Dollar will rise. If FED loosens the monetary condition, the opposite, that is, lower Dollar and higher stock prices, will take place. It should be noted that the correlations between higher Dollar and lower stock prices, and lower Dollar and higher stock prices, as discussed here, are opposite to the widely held belief of many market participants. However, such correlations does not imply that the currency movements have caused stock prices to move since both movements are just the result of one cause, the monetary action of FED. When Dollar falls sharply, stock prices tend to drop in tandem for a while. Such moves are due to psychological shocks on investors and are not based on any fundamental connection between the dollar pool and the investment pool. As the proof, such stock price moves are often short lived and are reversed soon through oversold conditions. There is indeed a long term and indirect cause and causality relation between the currency movement and stock prices. That is, a long term trend change in the exchange rates of Dollar will affect US trade deficits, and the change of trends in trade deficits, as discussed in the previous paragraph, is a potent force to move stock markets, especially at the time when US trade deficits have become so large. For example, the drastic devaluation of Dollar vs. Japanese Yen in 1985 resulted in the stagnation and then fall of US trade deficit in 1987, and the crash of stock prices of 1987 followed. Again, when Dollar fell sharply against Yen in the middle of 1998, in the middle to late 2000 US trade deficit stagnated and US stock prices started to fall from its peak. Investors who sold their stock holdings at the middle of 1998 when Dollar tumbled against Yen would have missed the best part of the stock market rally of late 1990's. On the other hand those who ignored the warning of the 1998 Dollar crash and held on to stocks pass the middle of 2000 would have suffered severe losses. It is interesting to observe that though strong expansions of trade deficits tend to support stock rallies, the beginning of the long-term rise of stock prices are not well coordinated with the start of a new phase of trade deficit expansion. This is due to the fact that at the nadir of trade deficit, the amount of trade deficit becomes relatively small so it does not become a potent force in shaping the size of investment pool; rather other factors like FED easing becomes the dominant factor in determining the size of the investment pool. However, at the peak of trade deficits, its influence on the size of investment pool is significant, and any stagnation or shrinkage of trade deficits has measurable effects on stock prices.