US Stocks and the US Dollar

Abstract

The purpose of this paper is to study the relation between US stock prices, as exemplified by the S&P 500 stock index, and the change in eleven foreign exchange rates against the US dollar. The null hypothesis of no-cointegration fails to be rejected for all dual specifications. Granger-causality tests on the log returns reveals no effect of the exchange rates on stock prices, but there is Granger causality of US stock prices upon three foreign exchange rates. The model developed requires the inclusion in the regressions of the change in the cost of equity. The latter is substituted for by the baa or the aaa corporate bond yield. All regressions are estimated with a GARCH(1,1) model of the conditional variance. The regressions of stock log returns on the log returns of each foreign exchange rate uncover significant impacts for five different rates. However when the ‘fundamental variable’ is added to the regressions, which is the change in the cost of equity, replaced by the change in the baa corporate bond yield, the above impacts reduce to only one with an additional impact that is marginally significant. If the change in the aaa corporate bond yield replaces the change in the cost of equity two significant impacts out of the eleven are found, with one additional marginal result. The evidence is therefore rather strong that the US stock market and the US dollar are effectively independent of each other once fundamentals are accounted for.