Figure 2.1.2.C Exchange Rates and Equity Prices

What the Figure Shows

Figure 2.1.2.C Scatter plot of monthly % changes in the US dollar index (Xaxis) against the S&P 500 total return index (Yaxis). Each dot represents one month from Jan2000 to Dec2023. The red regression line indicates the fitted relationship.

The graphic is a scatter plot with the following key features:

• Xaxis: Monthly percentage change in the US dollar index (a proxy for the overall strength of the dollar against a basket of currencies).
• Yaxis: Monthly percentage change in the S&P500 total return index, which reflects the combined performance of U.S. equities, including dividends.
• Data points: Over 280 observations (one per month) plotted to capture the joint distribution of the two variables.
• Regression line: A statistically significant negative slope, suggesting that, on average, a stronger dollar coincides with lower equity returns.
• Confidence band: Shaded 95% confidence interval around the regression line, illustrating the range of plausible outcomes.

Economic Intuition Behind the Relationship

Several channels link exchangerate movements to equityprice dynamics:

1. Export Competitiveness: A weaker domestic currency makes exported goods cheaper for foreign buyers, boosting earnings for exportoriented firms. Conversely, a stronger currency erodes export margins.
2. Import Costs and Inflation: A stronger currency reduces the cost of imported inputs, potentially improving profit margins for firms that rely on foreign raw materials. However, lower import prices can also suppress inflation, leading central banks to keep interest rates low, which tends to support equity pricescreating a nuanced net effect.
3. Foreign Investment Flows: When a currency appreciates, foreign investors can purchase fewer domestic shares with the same amount of foreign currency, reducing demand for equities. Depreciation can have the opposite effect.
4. CurrencyHedging Activity: Large institutional investors often hedge foreignexchange exposure. Hedging demand can amplify or offset the direct impact of currency moves on stock prices.
5. RiskOn/RiskOff Sentiment: In periods of global risk aversion, investors flock to safehaven assets such as the US dollar, pushing it higher while pulling money out of riskier equity markets.

Figure 2.1.2.C captures the aggregate outcome of these forces, with the prevailing negative slope reflecting the dominance of the exportcompetitiveness and risksentiment channels for the United States during the sample period.

Statistical Highlights

• Correlation coefficient (r): 0.38, indicating a moderate inverse relationship.
• Regression equation: Equity% = 0.12 0.45Dollar% (p<0.001).
• Adjusted R: 0.14, meaning roughly 14% of the monthtomonth variation in equity returns is explained by exchangerate changes.
• Standard error of the estimate: 2.6% monthly equity return.

While the statistical fit is not perfectequities are influenced by many other variablesthe significance level confirms that the observed link is unlikely to be a product of random chance.

Implications for Different Market Participants

Investors

Portfolio managers can incorporate currency exposure as a systematic risk factor. For instance, a longshort equity strategy that goes long on firms with high export exposure and short on importheavy companies may benefit from anticipated currency moves.

Corporations

Multinational firms should monitor the dollars trajectory when setting pricing, budgeting, and hedging policies. A persistent appreciation may justify shifting production overseas or renegotiating supplier contracts.

Policymakers

Central banks need to be aware that aggressive monetary easing, which tends to weaken the domestic currency, can provide a boost to equity markets through the export channel. Conversely, tightening may have a dampening effect on both the currency and equities.

Limitations of the Figure

Although Figure 2.1.2.C offers valuable insight, several caveats must be kept in mind:

• Sample Period Bias: The 20002023 window includes major events such as the 2008 financial crisis and the COVID19 pandemic, which may have amplified the observed relationship.
• SingleCountry Focus: The figure examines only the US market. Emergingmarket equities often exhibit a stronger positive correlation with their own currency movements.
• Lag Effects: The plot uses contemporaneous monthly changes. In reality, currency adjustments can affect earnings with a lag of several quarters.
• Omitted Variables: Factors like interestrate differentials, commodity prices, and geopolitical risk are not captured but can confound the relationship.

Further Research Directions

To deepen understanding, researchers might explore:

1. Panel regressions across multiple economies to assess whether the negative slope holds universally.
2. Highfrequency (daily) analyses that separate shortrun speculative moves from longerterm fundamentals.
3. Structural models that explicitly incorporate hedging behavior and capitalflow dynamics.
4. Eventstudy approaches around major currencypolicy announcements to isolate causal impacts.