Decoupling a Stock Recovery from a Weak US Dollar
With signs of a global economic recovery, investors and traders have tepidly repositioned themselves in various financial markets. However, occasional dire news about faltering growth, exploding deficits and potential defaults has periodically sent them scurrying back to the sidelines. Risk on, risk off markets are characterized by traders and investors alternating between risky assets like stocks, commodities and growth currencies, and risk-averse assets like US Treasuries, the US Dollar and the Japanese Yen.
Two years after the fire sale of Bear Stearns kicked off an epic meltdown on Wall Street, the Dow Jones Industrials have recovered more than 50% of its losses from its nadir of 6,470. If stocks are poised to go higher, then one might expect the US Dollar to lose the attraction of its safe-haven status and resume its downward trend. However, lately the US Dollar seems to be buoyed by some new found strength at the expense of the weakened euro, which has been paralyzed by the never-ending saga of sovereign debt problems in Greece. So the question is: Is the US Dollar no longer a proxy for the risk on, risk off schizophrenia in the markets?
US Dollar Index Weekly Chart with Dow Jones Industrials overlay
As Bear Stearns teetered on the brink of collapse in March 2008, stocks began a decline that would eventually take the Dow below 6,500. Mirroring the down move of stocks was an up move in the US Dollar which accelerated as Lehman imploded and the global financial system went into an unprecedented credit freeze. Liquidity was at a premium, and the US Dollar was king. After marking its high at 89.60 in March 2009, a sustained recovery began in stocks and the US Dollar resumed its decline. This inverse relationship between stocks and the US Dollar (and to an extent the Japanese Yen) continued until late 2009 when the US Dollar turned up again from the 74.20 low without a commensurate pullback in stocks.
EUR/USD Weekly Chart with Dow Jones Industrials overlay
USD/CAD Weekly Chart with Dow Jones Industrials overlay
Without the fiscal challenges of the P.I.G.S. that have hobbled the euro, the Canadian Dollar, buoyed by recovering commodity prices, strong domestic growth and a stable banking system, has been a much better proxy for global growth and therefore stock prices. However, this relationship may also be vulnerable to decoupling at some point in the future. The export sectors of the Canadian economy will have difficulty sustaining another 10% rise in the Loonie without suffering competitively, notwithstanding how capable and adept exporters have become at hedging currency exposure. So it is conceivable that while stocks may gain further ground with global economic recovery, the rate of ascent for the Loonie may slow down even in the face of impending BoC rate hikes.
Looking Ahead to the rest of 2010
The Goldman fraud charges and the economic fallout from the volcanic eruptions have been the catalyst for over-extended stocks, commodities and some currencies to catch a breath. In the past 36 hours the relationship between retreating financial markets and a resurging US Dollar has been re-established. However, once traders digest and discount the Goldman news, and the skies over Europe clear up again (literally), markets will stabilize and resume their upward trajectory, provided the recovery picture continues to brighten, especially on the jobs front.
US Dollar bears have long been focused on the money printing vices of the Fed and the gargantuan US deficits as the rationale for the inevitability of its long term decline. After all, there are numerous examples to reference in history, the Weimar Republic in the 1920s to most recently Zimbabwe. However, that is giving too little credit to the as yet unchallenged status of the Dollar as the primary reserve currency, and the resilience and dynamism of the American economy. To knock the US Dollar off its perch, there needs to be a credible alternative, which so far cannot be found in the euro hobbled by sovereign debt problems, or the Yuan with its under-developed capital markets.
For the balance of 2010, currency markets will likely be dominated by individual stories rather than an overriding US Dollar theme. The Canadian Dollar’s performance will hinge on whether the BoC can deliver its promised rate hikes, but one should be cautious that a lot, if not most, of the Loonie’s appreciation may have already been seen irrespective of impending rate hikes. The Australian Dollar buoyed by rates lifted much earlier can only sustain its rather lofty levels if the Chinese economy continues to grow, and the property markets do not implode from speculative excess.
The euro’s problems stem from the disparate economies in the eurozone and the inabilities of member countries to depreciate their national currencies or change interest rates to cope with their specific economic and fiscal challenges. Sterling’s angst will linger, leading up to national elections on May 6th especially in light of the increasing likelihood of a minority government, with the Liberal Democrats emerging as the power broker. The U.K. obviously has other pressing concerns, including a sluggish economic recovery, rising deficits and continued job losses in the financial sector.
Meanwhile, in case you haven’t paid attention recently…….
USD/CAD – Still Here After All These Years (40 to be exact)
The more things change the more they stay the same. A quick look at the chart above reveals that the Loonie has not really moved all that much over the last 40 years relative to the US Dollar, if you are Rip Van Winkle waking up from a deep 40 year long slumber. After the inflation ravaged 70s, the deficit-ridden 80s, the belt tightening 90s and the liquidity soaked 00s, USD/CAD is right back where it was. 40 years ago.
GBP/JPY – A Pound of Yen was a Lot More Back Then
One of the infamous carry trades that blew up along with the rest in the global financial crisis was GBP/JPY, which earned an average carry of about 4% during its run up from 150 to 250 between 2001 and 2008. In 1974 one Pound Sterling fetched over 700 Japanese Yen, and although the Yen began its inexorable climb against most major currencies in the next 40 years, it has not hampered the ability of Japanese exporters to compete globally.
