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We’ve seen some weird things happen in markets over the past year and a half.

The recent combined rally in oil and the U.S. dollar is near the top of the list.

The price of West Texas Intermediate (WTI) crude oil and the dollar have risen together for the past five weeks, the first time that’s happened in our data going back to 1983.

Graph titled The Dollar and Oil Prices Sync Up tracks the U.S. Dollar Index against oil prices in 2021 so far. Historically, the two tend to move opposite each other, which makes their tight correlation in September and October 2021 an unusual occurrence. Source: Ally Invest, Bloomberg

Not only is this a rare event historically, but it also doesn’t make a lot of sense. Oil and the dollar tend to move in opposite directions because crude prices are quoted in dollars. Typically, as the dollar rises, global demand for oil naturally declines (because it’s more expensive).

While you may not be an oil day trader, the crossed wires between crude and the dollar could eventually impact your stock portfolio.

So, what’s going on?

The Dollar

Let’s start with the dollar.

For the past year and a half, historic Fed intervention and trillions in government spending have helped push the dollar consistently lower versus other major currencies (higher supply = lower value).

That trend flipped when summer started. From the end of May until the end of September, the dollar gained nearly 5% versus other major currencies, the biggest four-month gain since 2018. There’s been a perfect storm of catalysts for the dollar’s rally, too. It seems to be the safest bet in currency land as concerns increase about supply chain issues and slowing growth in emerging markets. Plus, the Fed has strongly hinted it’ll start tapering this year, a vote of faith in the U.S. economy that’s boosted the appeal for the dollar even more.

Strangely enough, the dollar’s reversal hasn’t upended stocks just yet, even though a weakening dollar helped propel the market earlier this year. Over the past decade, the dollar and the S&P 500 have largely moved in opposite directions when looking at six-month correlations. Nearly 50% of S&P 500 sales come from overseas, so a higher dollar eats away at growth.

Chart titled Stocks-Dollar Relationship Can Change Quickly tracks the 6-month correlation between the S&P 500 and the U.S. Dollar from 2011 through 2021. Periods of negative correlation include most of 2011 through early 2014, mid 2015, late 2016, early 2018 through mid 2019, and late 2020 through October 2021. Source: Ally Invest, Bloomberg

Oil

Enter oil.

Oil has been a tough market to read since COVID started. In fact, the price of oil even fell negative back in April 2020. Now, oil is back at a seven-year high because people are driving and traveling more as COVID cases recede. Surging coal and gas prices from China’s energy crisis is making oil an attractive alternative.

There are supply issues, too. Active oil drilling rigs are still about 40% below pre-COVID levels, and OPEC forecasts show supply may not increase substantially any time soon. Hurricane season and the impact of Ida doesn’t help. Hence, crude’s 30% rally since August, even in the face of a surging dollar.

The Broader Storylines

The dollar and oil may be in an unusual spot, but they’re both supporting characters in broader market storylines. Rising oil prices are good in that they could signal more demand, but they could also point to lingering inflation. A higher dollar reinforces the U.S. economy’s strength versus the rest of the globe, but ideally that strength comes amid worldwide growth, not a deceleration.

For stock investors, it’ll be key to see which market flinches first for a few reasons. First, the economic outlook tends to drive the overall market, and these two markets are sending mixed signals on that front. Any quick change in either oil or the dollar could grab hold of the stock market.

It could also signal another change in market leadership. Energy stocks have led the S&P 500 higher over the past three months, in part thanks to oil prices. And the Russell 2000 Index of small-cap stocks, which stands to gain the most from a strong dollar, has beaten other major indexes over the same timeframe. If history is any guide, oil and the dollar may not be in lockstep for much longer, adding near-term risk to groups like these. Swift changes in leadership could be enough to rattle the market, and a quick reversion to the mean in either the dollar or oil could become uncomfortable.

We’re watching the Fed’s next moves, OPEC’s oil reserve decisions and the situation in China for clues on where the oil and the dollar are heading. The dollar may be more susceptible to a pullback at this point as it bumps up against technical pressures and as inflation remains elevated. Alternatively, if the dollar and oil prices stabilize, that may just be the ideal outcome for the market.

The Bottom Line

When market correlations break down, it’s important to pay attention. Markets around the world are more interconnected than ever, and dislocations can be sources of opportunity.

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Callie Cox, senior investment strategist, contributed to this article.

Speech bubble icon next to text "Expert Take"

Headshot of Lindsey BellLindsey Bell is Ally’s Chief Investment Strategist, responsible for shaping the company’s point of view on investing and the global markets. Lindsey has a broad background in finance, with experience on the buy-side and sell-side, in research and in investment banking and has held roles at JPMorgan, Deutsche Bank, Jefferies, and CFRA Research.

Lindsey holds a passion for teaching individuals how to become successful long-term investors. She is a contributor at CNBC, and frequently shares her insights with various publications including the Wall Street Journal, Barron’s, MarketWatch, BusinessInsider, etc. She also serves on the board of Better Investing, a non-profit organization focused on investment education.

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