[LFX]

In recent times, the market has slavishly followed a phenomenon where a rise in so-called risk aversion has been associated with USD strength and vice versa with a move towards more risky investments linked to USD weakness. In terms of the US economy itself, this has shown up in the form of ‘bad’ economic news being associated with USD strength and ‘good’ economic news with USD weakness.

This is perhaps best shown in the correlation between US share prices (as a proxy for risk appetite) and the USD index. In the last year or so, but certainly since the start of the economic and financial crisis, most moves in share prices has been matched by an opposite move in the USD.

This FX market phenomenon does not apply to any other countries when bad domestic economic news is associated with currency weakness and vice versa. Note some recent trends in the UK, for example, where bad news has seen the
GBP fall and good news in Australia has seen the AUD rise. This is how a system of floating exchange rates should respond.

The issue of the USD appearing to trade perversely to fundamentals raises a number of questions. One is whether this will change at some stage – perhaps when the US economy unambiguously improves – or whether in fact the phenomenon is a function of the USD being the world’s reserve currency, or even whether there are other reasons explaining the USD movements.

Markets can over-shoot and stay well away from fundamentals for expended periods, but ultimately, the value that matter), must be based on something substantial. This is why the current method of trading the USD may start to break down at some stage. The current fashion of selling the USD on good news and vice versa is not sustainable over the longer run. One thought is that once markets settle down from the ructions of the global financial crisis and the world
economy enters a sustainable expansion, the focus on USD fundamentals is likely to return.

Looking at the longer run link between risk and the USD (the same chart as above but over the past 15 years) and it is clear that the link does not hold. A booming stock market from about 1995 to 2000 was associated with USD strength.