[cppene]

Ever since last week’s nonfarm payrolls report, when the US dollar and equity markets both rallied on the day, there has been increasing chatter about the possible breakdown of the bad news - strong US dollar (and vice versa) relationship that has persisted since last autumn, after the failure of Lehman Brothers. However, despite the one-day reaction last Friday, it appears as if the USD-risk inverse relationship is as strong as it ever was. You can look at the US dollar versus economic data surprises, crude oil prices, equities, or copper, to name a few, but the inverse correlation is still extremely strong. For now, we still seem to be stuck in a world where everything is correlated to everything else; the risky assets move with the other risky assets, and the safe havens move with the other safe havens.

This of course leads to the question of when, or even if, these relationships are going to break down. We start with the question of “if.” Looking at the USD versus risky asset relationship from a longer-run point of view, the USD has been negatively correlated with both copper and crude oil prices on a pretty consistent basis for the last several years. Just not to the extremes that we’ve seen since last fall. But the USD-equity relationship has never (in the last couple of decades) been consistently negative for this long, nor to these extremes. The relationship between economic data and the USD though is the one that’s the most “wrong”;
typically better than expected data helps to support the USD, as markets price in larger/sooner interest rate hikes from the Fed. But that hasn’t been the case since last fall, as the relationship between the two switched from consistently
positive to consistently negative. So for the USD-commodity relationships we’re merely looking for a “loosening” compared to what we’ve seen over the last few months; at the same time we’re looking for a complete breakdown of the USD-equity connection, and an outright reversal of the USD-economic data movements.

That brings us to the question of when we expect these breakdowns to occur. The differential in real interest rates between the world’s major countries is extremely low right now, and global real rates are essentially moving in tandem. The major central banks have all reached the troughs of their interest rate cycles, and given the uncertainty in economic forecasting right now, no one can really be sure who is going to start hiking rates first, as that’s still several months or quarters down the road for most developed countries.

Until markets get a better grasp of which central bank is going to pull the interest rate trigger first (or at least begin reducing their balance sheets) and real interest rates begin to diverge, currency markets are going to continue to move in the same fashion, buying the USD in times of risk aversion, and selling it when risk is back on again. Once the world’s central bankers start dropping some hints that rate hikes are coming, the USD will start moving with interest rates and general economic fundamentals again, and will finally move away from the risk-on/risk-off patterns.

So for the time being, we’re going to continue to watch equities and other risky assets to gauge the direction of the USD.