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Research:
The Dow and the Dollar - Strong Correlation

28th December,1999
                                                                        Study Reviewed on 2nd July '00

Graph


Trends in 1999 The currency market witnessed two main trends in 1999 - the Euro's decline and the rise of the Yen. These trends coalesce into a 21.5% decline in Euro-Yen, from 132 in the beginning of the year to 102 in December. In the last quarter of the year, the market witnessed a very strong correlation between the strength of the US Equity market and the strength of the US Dollar a gainst the Euro. The common refrain in the currency market was, "The Dow leads the Euro pip-by-pip." In this paper we examine the relationship between the Dow Jones Industrial Average and the Dollar-Euro rate (EURUSD inverted) more closely.
   
Dow-Dollar are highly correlated
Period Corelation
Jan'94 to Current 78.90%
Jan'94 to March'95 -45.65%
April'95 to Current 92.43%
As can be seen in the Chart above, the DJIA and the Dollar have moved largely in tandem after 1995. The period 1994 to 1999 itself displays a high correlation on 78.9%, but this can be broken into 2 periods, as seen in the table alongside (detailed table provided at the end). From this we draw an obvious conclusion - the Dollar strengthens along with the Dow.
   
Vulnerability There is a flip side to this observation - When the Dow is not rising, the Dollar falls. In fact, the Dollar tends to fall more (in relation to its own range) than the Dow in such periods.

Observe the periods Aug-Oct '97, May-Aug '98 and July-Oct '99. In these periods, each lasting 3-4 months, the Dow fell an average of 14% (6.8% of its entire 1994-199 range) and correspondingly the Dollar fell an average of 7%. (64.42% of its entire 1994-199 range). Even the period Jan '94 to March'95 exhibits the same features - the Dow rose very slowly, accompanied by a prominent downtrend in the Dollar.

The Dollar is disproportionately vulnerable to weakness in the Dow.

   
Polynomial Curves We have plotted Polynomial curves of the 6th degree for both markets. Their projected values 60 trading days hence can be seen on the graph above.

According to these projections, the Dow should continue to rise (but with lesser momentum than seen till now) to reach a little higher than 11500. This is in keeping with our earlier analysis (see "The Colour of Money" dated 21/12/1999) wherein we have contended that the Dow should not see a sustained rise beyond 11600 over the next 2-3 months.

The curve for the Dollar-Euro rate indicates a sharp increase in the Dollar's strength, taking the rate to 1.10 (or the Euro-Dollar rate to 0.9090). We are inclined to take this projection with a pinch of salt. Here is why:

  1. the polynomial has never risen so sharply (as projected) in the period considered. The natural question is, can it now rise exponentially?
  2. If the Dow is not expected to rise very sharply, then it should not be possible for the Dollar to rise sharply either. As such, once again the projection is suspect.
And if the actual market does turn out to obey the polynomial's projection, the Dollar's strength can be expected to be capped near 1.10 (or 0.9090 on the Euro-Dollar rate).
   
Conclusion - Careful on the Dollar, please If, for any reason (fundamental and or technical), you happen to view the bullishness for the US economy (read Nasdaq / Dow) and the US Dollar with caution or dread, this piece should give you another reason to add to your list of worries.

There would have to be some sea-change, something totally unexpected, something not yet priced into the market, something which is exceptionally favourable to the USA for the Dow and the Dollar to continue to soar.

Apart from all of the above, in the markets, they say, it pays to Buy Low and Sell High.

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