The Relationship Between Exchange Rates and Stock Markets

If you follow financial markets, you have probably noticed that currency movements and stock market swings often happen at the same time. A weakening dollar might coincide with rising US stocks, or a currency crisis in an emerging market might trigger a sell-off in that country's stock exchange. These connections are not coincidental.

Understanding how exchange rates and stock markets interact can help you make better investment decisions, manage risk more effectively, and interpret financial news with greater clarity.

The Basic Connection

Exchange rates and stock markets are linked through several channels:

• Trade competitiveness: Currency values affect corporate earnings
• Capital flows: Investors move money across borders, influencing both markets
• Monetary policy: Central bank decisions impact currencies and stocks simultaneously
• Risk sentiment: Global risk appetite drives both currency and equity markets

Let us explore each of these connections in detail.

How Exchange Rates Affect Stock Markets

The Export Effect

When a country's currency weakens, its exports become cheaper for foreign buyers. This benefits export-oriented companies, whose revenues increase in local currency terms even if their foreign currency sales stay flat.

Example: If the Japanese yen weakens from 110 to 140 per dollar, a Japanese automaker selling cars in the US for $30,000 each now receives 4,200,000 yen per car instead of 3,300,000 yen. Their yen-denominated revenue jumps 27% with no change in the dollar price.

This is why the Japanese stock market (Nikkei 225) often rallies when the yen weakens. Export-heavy economies like Japan, Germany, and South Korea show a particularly strong inverse relationship between their currency and stock market.

The Import Cost Effect

A weaker currency also makes imports more expensive. Companies that rely heavily on imported raw materials, components, or goods see their costs rise, which can squeeze profit margins.

Example: A US retailer that imports products from China will face higher costs if the dollar weakens against the yuan. Unless they can raise prices, their margins shrink and their stock may underperform.

The Foreign Investment Effect

When a country's currency is expected to strengthen, foreign investors are attracted not only by potential stock market returns but also by potential currency gains. This double incentive can create a virtuous cycle: foreign investment pushes up stock prices AND strengthens the currency, attracting even more investment.

The reverse is equally powerful. When a currency starts falling, foreign investors may sell their stock holdings to avoid currency losses, creating a vicious cycle of declining stocks and a weakening currency.

How Stock Markets Affect Exchange Rates

The relationship runs in both directions. Stock market performance also influences currency values.

Capital Attraction

A booming stock market attracts foreign capital. To buy stocks in another country, investors must first purchase that country's currency. Strong stock market performance can therefore strengthen a currency through increased demand.

Example: The tech-driven rally in US stocks from 2020-2024 attracted massive global investment, supporting dollar strength as international investors converted their local currencies to dollars to buy US equities.

Risk Sentiment and Safe-Haven Flows

During global stock market sell-offs, investors tend to flee to safe-haven currencies like the US dollar, Japanese yen, and Swiss franc. This flight to safety simultaneously depresses stock markets in riskier countries and strengthens haven currencies.

During risk-on periods when stocks are rising globally, the opposite happens. Investors sell safe-haven currencies and move into higher-yielding or higher-growth-potential currencies and stock markets.

Key Patterns to Understand

Pattern 1: The Weak Currency / Strong Stocks Relationship

In export-driven economies, a weakening currency often coincides with rising stock prices. This is because:

• Corporate earnings improve in local currency terms
• Exporters gain competitive advantages
• Central bank policies that weaken the currency (like low interest rates) also support stocks

Where you see this: Japan, South Korea, Germany, and other major exporters.

Pattern 2: The Currency Crisis / Stock Crash Spiral

In emerging markets, a sudden currency collapse can devastate the stock market through:

• Foreign investors rushing to exit, selling both stocks and the currency
• Companies with dollar-denominated debt facing ballooning repayment costs
• Imported inflation eroding consumer spending power
• Central banks hiking interest rates to defend the currency, choking economic growth

Historical examples: The 1997 Asian Financial Crisis, the 2018 Turkish lira crisis, and various episodes in Argentina and Brazil.

Pattern 3: The Commodity Currency / Resource Stock Link

Countries whose currencies are heavily influenced by commodity prices (Australia, Canada, Norway, Brazil) show a strong link between their currency and their resource-sector stocks. When oil or iron ore prices rise, both the currency and resource stocks tend to gain together.

Pattern 4: Interest Rate Divergence

When one country's central bank raises rates while another holds or cuts, the higher-rate country's currency typically strengthens. This can hurt its export-oriented stocks but benefit its financial sector (banks earn more from higher rates).

Practical Implications for Investors

International Stock Investors: Watch the Currency

If you invest in foreign stocks, your total return has two components:

1. Stock performance in the local currency
2. Currency movement between the local currency and your home currency

A stock that rises 15% in yen terms but during a period when the yen falls 10% against the dollar would deliver only about a 5% return to a US-based investor.

This is why many international ETFs and mutual funds offer both "hedged" and "unhedged" versions. Hedged funds neutralize currency effects, while unhedged funds give you full exposure to both stock and currency movements.

Hedging Decisions

Consider currency hedging when:

• You have a large position in a single foreign market
• The foreign currency is near a multi-year high (higher risk of depreciation)
• You need predictable returns for financial planning

Skip hedging when:

• You believe the foreign currency will strengthen
• Your investment horizon is very long (currency effects tend to average out over decades)
• Hedging costs are high relative to your expected return

Using Currency Trends as Stock Market Signals

Currency movements can provide early signals about stock market direction:

• Strengthening yen or Swiss franc: Global risk appetite may be declining; consider reducing exposure to risky assets
• Weakening emerging market currencies: Potential trouble ahead for those stock markets
• Dollar weakness: Often positive for US multinational earnings and international stocks
• Rising commodity currencies: Likely positive for resource-sector stocks

Building a Currency-Aware Portfolio

Step 1: Know Your Currency Exposure

Map out the currency exposure of your investment portfolio. A portfolio of US stocks still has significant international currency exposure if those companies earn revenue abroad.

Step 2: Diversify Across Currencies

Just as you diversify across asset classes and geographies, consider diversifying your currency exposure. Holding investments denominated in multiple currencies can reduce the impact of any single currency's decline on your portfolio.

Step 3: Monitor Macro Indicators

Keep an eye on the macroeconomic factors that drive both currencies and stocks:

• Interest rate decisions and forward guidance from central banks
• Trade balance data
• Inflation reports
• Political events and geopolitical risks

Step 4: Rebalance Periodically

Currency movements can drift your portfolio away from your target allocation. If one currency has strengthened significantly, your holdings in that currency may have grown beyond your intended weighting. Regular rebalancing helps maintain your desired risk profile.

Conclusion

Exchange rates and stock markets are deeply intertwined. Currency movements affect corporate earnings, investor flows, and risk sentiment, all of which drive stock prices. Simultaneously, stock market performance attracts or repels international capital, influencing currency values.

For investors, this means that understanding currency dynamics is not optional. Whether you invest purely in domestic stocks or hold a globally diversified portfolio, exchange rate movements are affecting your returns. By recognizing the key patterns, monitoring currency trends, and making informed hedging decisions, you can turn this knowledge into a practical advantage in your investment strategy.