Stocks Wag the Dollar

The most important factor moving the U.S. and global currency markets these days is simple: the volatile stock market.
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There are a lot of pretty theories people use to judge where a currency is headed. Some follow interest rates. Others look at economic performance. Then there's a school that reckons the cost of goods is what matters.

But these days, stocks are the thing to watch.

"The equity markets are the moving markets," says Lisa Finstrom, currency strategist at

Salomon Smith Barney

. "They're the hot market."

Capital flows certainly bear this out. Foreign investors placed an unprecedented $108 billion into U.S. equities last year, according to

Morgan Stanley Dean Witter

estimates. At the same time, fixed income has been exerting less of an influence on the dollar than before. In part, that's because it really hasn't been a very exciting market over the last year, merely a depressing one. Moreover, many global investors got gun-shy of fixed income after the 1998 credit crisis.

"In the old days, it used to be about chasing yield," says David Gilmore, a partner with

Foreign Exchange Analytics

. "Now we've turned it around and it's about chasing equities."

Soros Makes a Lucrative Switch

For example, George Soros'

Quantum Fund

, a $10 billion global hedge fund open only to non-U.S. investors, used to be strongly focused on fixed-income and currency plays. After July of last year, its focus shifted to tech stocks -- most of which dwell in the U.S. -- and at the same time it reportedly also unwound a bet that the euro would strengthen. According to

The Wall Street Journal

, the Soros moves turned a 19% loss earlier last year into a 35% gain for all of 1999.

And one suspects it's not just Soros who pursued this course. Against the mark (a good historical proxy for the euro), the dollar in 1999 showed the highest degree of correlation with the

Dow Jones Industrial Average

that it has in 19 years, according to a report from

Warburg Dillon Read

.

More recently, the stock focus of the currency market has narrowed -- these days it's the fortunes of tech stocks that make the dollar wax and wane against the euro. Regression analysis -- a method of seeing how well one market tracks another -- shows a sharp rise in the correlation between the

Nasdaq 100

and dollar/mark beginning last November.

Other countries have also seen market strength translate into currency strength. Many global portfolio managers were underweight Japan last year, got caught off-guard by the

Nikkei's

73% advance and had a lot of catch-up investing to do.

Foreign investors put a net 12 trillion yen (about $110 billion at today's rates) into Japanese stocks last year, according to Japan's

Ministry of Finance

-- up 480% from 1998. It's one of the reasons the yen tacked on 10% against the dollar last year, despite the Japanese government's efforts to the contrary.

In some emerging markets, too, there have been stronger links between currency and stock performance over the last year. The won has been well-correlated with Korean stock performance, as has the Mexican peso with the

Bolsa

.

"In emerging markets, you get a tight correlation," says Carlos Asilis, emerging market strategist at

J.P. Morgan

. "When local indices go up, more often than not, currencies strengthen."

Caution: Emerging Markets Still Emerging

These links between stocks and currency don't come without perils, however. Investors in Mexico last year were doubly blessed -- they got a 73% Bolsa return compounded by a 4% return on the peso -- but if Mexican stocks correct, the peso will fall, too, and investors will be doubly damned.

"For emerging markets, you have this concern," says Finstrom. "How resilient or flexible are they? Are they as flexible as they need to be to deal with quick shifts?" If they are not, investors cashing positions could send a currency down sharply, which, in turn, would prompt more stock selling, sparking a vicious cycle of capital flight.

But maybe the thing to worry about most is the way the dollar is tracking U.S. stocks. The implication that global portfolio managers are focused mainly on equities, and particularly tech, is discomfiting.

"When markets get hot and heavy about a particular asset class," says Gilmore, "you get these lopsided positions." He worries that if global investors get spooked, they'll pull out of the market

en masse

. There's certainly precedent: A big reason for the 1998 crisis was a flight out of emerging-markets bonds by these same investors. A repeat performance is something nobody wants to see.