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How Stock Market Volatility Influences the U.S. Dollar Exchange Rate

By Frances Coppola

After a calm 2017, volatility seems to be back with a vengeance. In FX markets, both trading volumes and price swings have increased since the start of 2018.1 And since the start of February 2018, stock markets around the world have been experiencing wild swings. On February 5th, the Dow Jones Industrial Average dropped nearly 1,600 points, its largest one-day fall in history (in points, not percentage).2 On the same day, the stock market volatility index (VIX) shot up, reaching its highest level in over 2 years.3

Although stock markets have since recovered much of the losses, the VIX remains elevated, showing that stock markets are still volatile.4 Some analysts predict that 2018 will see more large stock market drops.5 Volatility could be here to stay.

 

The Exchange Rate-Stock Market Relationship

 

Volatility in stock markets tends to be accompanied by currency volatility, because investors buying stocks may need to obtain currency to settle trades while investors selling stocks receive currency that they may need to exchange. Consequently, an increase in FX volatility can be explained by increasing stock market volatility, and vice versa.

 

However, the behavior of the dollar's exchange rate tends to be a bit more complicated. The dollar fell throughout January for reasons that may be related to changes in the U.S.'s trade balance. But in February, as stock prices fell, the U.S. dollar's trade-weighted exchange rate rose.6

 

Conventional view holds that stock prices and exchange rates are positively correlated.7 So, when the U.S. stock market is rising, the exchange rate of the dollar also rises. And when the stock market is falling, the dollar falls. Similarly, when the outlook is good, investors tend to buy stocks and hold the currency. When the outlook is gloomy, investors may sell both stocks and currency. Exchange rates and stock prices tend to move together since the stock market and the currency exchange rate are considered measures of confidence in the economy.

 

From 2014 through 2016, the dollar's exchange rate8 did rise more-or-less in parallel with the S&P 500.9 But in 2017 and so far in 2018, this relationship appears to have broken down. In 2017, the stock market rose continually throughout the year,10 but the dollar's exchange rate fell until September then recovered briefly before falling again from October onwards.11 And in 2018, the correlation has been negative.12

 

Uncertainty May Explain the Dollar's Exchange Rate

 

The VIX is a mathematical calculation of the "implied volatility" of options trading on the S&P 500 index. Also known as the "fear" index, it attempts to measure the likelihood of unpredictable changes and uncertainty in stock option prices. The higher the VIX number, the greater the likelihood of sudden price swings. Option prices reflect expected stock prices, so the greater the likelihood of unpredictable price changes, the greater the likelihood of sudden increases or decreases in stock prices.13

 

When uncertainty is high, investors may adopt risk-averse investment strategies. Typically, this would involve selling riskier stocks and bonds, and buying safer ones such as U.S. Treasury bonds (USTs). Investors may also choose to hold cash, since cash is the most liquid investment and fully guaranteed by government.

 

When the VIX rose sharply in February as stock markets fell, the dollar's exchange rate rose, and short-term UST yields briefly fell.14 This can be explained by investors selling stocks and reinvesting in safer USTs and cash. The increasing uncertainty at the time of the historic stock market decline in early February 2018 may have caused the dollar exchange rate to rise as investors sought to buy and hold such low-risk dollar-denominated assets.

 

The

Takeaway:

High stock market volatility can cause the U.S. dollar exchange rate to rise as a byproduct of increasing demand for "safe" dollar-denominated assets. Businesses may wish to keep an eye on the VIX and other indicators of market uncertainty when devising FX management strategies.

Frances Coppola - The Author

The Author

Frances Coppola

With 17 years’ experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.

Sources

1. “FX Volatility Boosts Trading, Amid Signs Of More To Come,” Bloomberg; https://www.bloomberg.com/news/articles/2018-02-13/fx-volatility-sparks-trading-surge-with-signs-of-more-to-come
2. “Dow’s nearly 1,600 point drop marks its biggest one-day point drop ever,” CNBC; https://www.cnbc.com/2018/02/05/dows-nearly-1600-point-plunge-marks-its-biggest-one-day-point-drop-ever.html
3. “Price charts on VIX,” CBOE; http://www.cboe.com/products/vix-index-volatility/vix-options-and-futures/vix-index/price-charts-on-vix
4. Ibid.
5. “The stock market correction two weeks later: how it happened, and if it can happen again,” CNBC; https://www.cnbc.com/2018/02/16/the-stock-market-correction-two-weeks-later.html
6. “U.S. dollar trade-weighted exchange rate, broad,” FRED Economic Data; https://fred.stlouisfed.org/series/TWEXB
7. “What is the correlation between American stock prices and the value of the U.S. dollar?,” Investopedia; https://www.investopedia.com/ask/answers/06/usdollarcorrelation.asp
8. “U.S. dollar trade-weighted exchange rate, broad,” FRED Economic Data; https://fred.stlouisfed.org/series/TWEXB
9. “S&P 500 10-year daily chart,” Macrotrends; http://www.macrotrends.net/2488/sp500-10-year-daily-chart
10. Ibid.
11. “U.S. dollar trade-weighted exchange rate, broad,” FRED Economic Data; https://fred.stlouisfed.org/series/TWEXB
12. “S&P 500 10-year daily chart,” Macrotrends; http://www.macrotrends.net/2488/sp500-10-year-daily-chart
13. “What is the CBOE Volatility Index (VIX),” Investopedia; https://www.investopedia.com/ask/answers/021015/what-cboe-volatility-index-vix.asp
14. “US Generic Govt 2 Year Yield Analysis,” Bloomberg; https://www.bloomberg.com/quote/USGG2YR:IND

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