It feels like the market has fallen in love with the very questionable correlation of Equities UP EURUSD UP and Equities DOWN EURUSD DOWN
Why do we say questionable? The fact is that this relationship has worked well during the financial de-leveraging period seen between July 2008 and March 2009. However outside of that period that relationship is spurious at best. In fact when one looks back to 1995 to a period incorporating both bullish and bearish equity trends and bullish and bearish USD trends the relationship does not hold up to scrutiny.
In the equity bull market period of 1995 to 2000 the pretty close relationship was that Equities went up and the USD went up and equities went down and the USD went down. Overall during that period we had a bull market in Equities and a bull market in the USD as capital flooded in the U.S.A.
Between 2000 and 2002 as equities fell the USD also fell overall. In both markets the most impulsive part of the move came when Equities fell sharply from March 2002 to August 2002 and the EURUSD went from .8600 to 1.02.
From March 2003 to December 2004 as Equities rallied strongly the relationship broke down and higher equities also saw a weaker USD(Could it be that the move to artificially low rates by the Fed of 1% by June 2003 and held there until June 2004 provided cheap liquidity to invest around the World?) But, then in 2005 as Equities continued to move higher the USD then strengthened. Why? There were predominately 2 reasons.
Firstly by the end of 2004 the whole World was bearish USD and short accordingly and then in 2005 we had HIA (The homeland investment act) which provided a once off benefit to companies to repatriate overseas profits at preferential tax rates. As a consequence of this once off event the USD strengthened for most of 2005.
Then from 2006 to 2008 we once again saw the USD weaken as equities went higher continuing the trend in place since 2002.
From mid 2008 we have pretty much seen the de-leveraging trade where lower equities gave a strong USD and vice versa as risk positions were unwound, credit stresses were severe and USD funding was a big issue for the Europeans.
The dynamic today, however, does not seem the same as then. A lot of the USD funding stresses seem to be behind us, the TARP and the stress tests seem to have soothed the financial market concerns. U.S. interest rates are effectively at zero, the housing market remains stressed and the economic data remains poor (sometimes better than expected but poor nonetheless).
The Fed has told us (As recently as today) that the USD is back to being a full blown funding currency
• Interest rates are effectively at zero
• They do not anticipate “normal” growth for a number of years to come and have little inflation concerns.
• They contemplated an expansion of “QE” (can this backdrop really make housing or Fixed income a “bargain” i.e. why would capital now flow into the U.S.?
We are effectively printing money, engaging in massive monetary easing, engaging in massive fiscal easing, running up huge budget deficits, still running a large trade deficit. Is this a set of policies that would normally be supportive of a currency? We don’t think so.
What the chart above shows is that the relationship between the USD and the stock market comes and goes depending on what else is going on.
As we have now moved from financial de-leveraging to economic de-leveraging, the USD can move in a more fundamental fashion. If so the fundamental policies noted above are likely to weaken the USD over the course of 2009 into 2010 irrespective of whether equities rally further or indeed fall. What may differ in bouts of risk on/ risk could be the currency of choice on the other side to buy against the USD.
With the U.S. consumer retrenching, losing jobs, worried about mortgages/pensions/college fees etc and SAVING the gap in an economy 72% driven by the U.S. consumer is going to continue to require a big Government presence in monetary and fiscal policy as well as printing money.
As a final note on a day when the S&P posted a bearish key day reversal EURUSD had its highest daily close in the up move from the 1.2457 March low and closed over the pivot post FOMC 1.3739 peak. In addition USDCAD closed below a major technical level at 1.1465.
It is early days but this may well be the early warning sign that the USD trade is no longer the risk on risk off trade that it has been since last July and that we may be on the cusp of more sustained broad based medium term USD weakness.
Questionable correlation of Equities and EURUSD
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