Why Does the Dollar Go up When Stocks Fall?

09/03/2009 12:01 am EST

Focus: FOREX

The US dollar has had a very strong inverse relationship with stocks recently. There are ways investors can take advantage of these movements.

The US dollar has two values. The first is its purchasing power. Inflation will hurt the dollar's ability to purchase goods, while deflation will increase the dollar's purchasing power. During 2007-2008, there had been very limited inflation or disinflation, which can be dangerous if it turns into true deflation. The second way to value the dollar is relative to other currencies. Forex traders are constantly betting on or against the dollar versus the world's other currencies. In fact, 86% of all forex trades involve the US dollar.

One of the things that will impact the US dollar's relative value against other currencies is trader risk sentiment. When investors are very concerned about global economic risks, it will gain in value as traders move into safer investments, which are often denominated in US dollars. This shift of capital from risky assets to safer assets will affect the major stock indexes like the S&P 500 (.INX) and the Dow Jones Industrial Average (.DJI).

Stocks are considered a "risky" investment relative to Treasury bonds or other "safer" assets. This means that when traders get worried about risk, stocks will fall and demand for the US dollar will rise. This is what we are seeing currently with a sinking stock market and a rising dollar. This inverse relationship may be useful to investors looking for diversification across asset classes.

By the Staff at LearningMarkets.com


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