The market value of the U.S. dollar has an impact on every segment of the economy, including the stock market. A strong dollar is synonymous with falling equity prices, while a weaker dollar can cause stock prices to rise. However, the relationship between currency valuations and the stock market is complex. A weak dollar is not necessarily good news for investors.
Before 1973, the Bretton Woods international monetary system determined the value of the U.S. dollar. In 1973, the federal government decided to float the dollar; the currency's value is now based on supply and demand. Commodities including gold and oil are priced in dollars. Foreign investors buy dollars to make transactions involving dollar denominated goods easier to facilitate. For the same reason, U.S. companies and investors buy euros, pesos and other currencies. Many foreign investors view the dollar as a safe haven investment and buy U.S. currency when other nations experience economic problems. Conversely, investors often sell dollars when the U.S. economy goes into a downturn.
If the dollar drops in value, the price of goods denominated in dollars increases. Consequently, stocks in energy companies may rise as the dollar weakens. Imports become more expensive after a dollar devaluation, but foreign companies can acquire American goods at lower prices. This helps to drive up exports. As exports increase, profits rise and stocks in U.S. companies rise in value. Investors attempting to profit from rising stock prices may shift their cash from bonds to stocks. The increased competition for stocks drives prices up even further.
So-called day traders are sensitive to current economic trends. These investors help to drive up stock prices when the dollar weakens. However, other investors take a longer-term view and analyze the underlying factors that have caused the dollar to fall in value. Issues such as excessive levels of government debt may raise red flags and suggest that the U.S. economy is headed into a downturn. Consequently, investors may shy away from stocks and move their money into safer investments, such as bonds. This action could cause the stock market rally to dissipate. On the other hand, if the long-term economic forecast looks good, investors may snap up stocks with the expectation that they can make gains as the economy stabilizes.
The U.S. stock market includes a variety of funds that trade currencies and assets denominated in dollars. Some funds attempt to capitalize on a strong dollar by investing in oil, gold and U.S. currency. Other funds take a contrarian view and bet against the dollar by investing in currencies from other nations. When the dollar drops in value, funds containing foreign currency and assets rise in value. The gains in these securities are offset by losses in funds tied to the dollar.
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