UNDERSTANDING THE FOREX- EQUITY CORRELATION

With the S&P 500 and Nasdaq hitting year to date highs, it should not surprise currency traders that the dollar has extended its gains. Since the beginning of the month, the dollar appreciated more than 5 percent against the Japanese Yen and over 4 percent against the euro, Australian dollar and Swiss Franc. The only currency that has been stronger than the greenback is the Canadian dollar and even then the loonie’s gains have been marginal. Today, the loonie remains the only currency to strengthen against the dollar. The correlation between the foreign exchange and equity markets continue to dominate trading but it is important to realize that this is a new development on a quiet trading week with unusually low volume and market participants.

Understanding the Correlation Between Currencies and Equities
The correlation that everyone is focused on is the positive correlation between the dollar and stocks. There is an expectation that the U.S. dollar and stocks will rise in tandem on the belief that investors in both markets are banking on an accelerating U.S. recovery. It also means that the dollar is keying off U.S. fundamentals and not risk appetite as stronger U.S. data bolsters the confidence and attractiveness of dollar denominated assets. Although this may seem logical to many investors, it has not been the case for most of the year. In fact the illogical behavior of the dollar selling off on good data and rising on bad has dominated trading. The following table illustrates how the correlation between the S&P 500 and currencies has changed. Between last Thursday and today, the S&P 500 has had a 96 percent negative correlation with the EUR/USD and a near perfect correlation with USD/JPY. In other words, since last Thursday, a rally in U.S. equities has coincided with a sell-off in the EUR/USD and a rally in USD/JPY. However this is a new development because over the entire month, the correlation between stocks and currencies has been very weak. If we take a step back and look at the correlation between currencies and equities over the past 6 months, we can see that previously, the EUR/USD rose alongside equities. It remains to be seen whether this new correlation can hold and if it does, it would break a relationship that has lasted for most of the year.

Economic Data Preview and Review
Meanwhile the stronger existing home sales report completely offset the market’s reaction to the disappointing GDP report. After last month’s solid number, many people believed that the pace of improvement in the housing market would slow and even though it did, the 7.4 percent growth was extremely impressive. The number of units sold in the month of November hit 6.54 million, the highest since Feb 2007. This suggests that we could see similar strength in tomorrow’s new home sales report. Personal income, personal spending and revisions to the December University of Michigan consumer sentiment report are due for release tomorrow. Stronger numbers are expected all around. As for growth, the third release of GDP revealed that the U.S. economy expanded by only 2.2 percent in the third quarter, a far cry from the initial estimate of 3.5 percent. The details of the report pointed to weaker growth in personal consumption, gross private investment and government consumption. Personal consumption was revised from 2.9 to 2.8 percent while PCE was revised from 0.5 to 0.4 percent.

EUR/USD: CLOSING IN ON SUPPORT

It has been a bad month for anyone long euros. The currency has been on a one way downtrend with virtually no recovery. However, relief may be in sight with the EUR/USD closing in on a very important support level. The 1.4185/90 level represents the September low as well as the 200-day SMA and the second standard deviation Bollinger Band. Part of the reason why the Eurozone has not rebounded is because economic data has been light and the reports that we have been released did not help the euro. For example, German consumer confidence for January fell from 3.6 to 3.3. This week is a very quiet week in the Eurozone with no meaningful economic reports. The only economic releases on the calendar tomorrow are German import prices and French consumer spending. Meanwhile, the rebound in EUR/CHF has been far from impressive. Having hit a high of 1.4989 intraday, the currency pair is ending the NY session closer to its low. Thanks to the prior stabilization of the Swiss Franc, exports increased 1.6 percent in the month of November. However along with a 0.6 percent rise in imports, the trade surplus actually fell from 2.44B to 2.14B.

GBP/USD: UK ECONOMY REMAINS IN RECESSION

The British pound continued to weaken against the U.S. dollar, breaking its 1.60 support level in the process. Although GDP growth was revised upwards from -0.3 to -0.2 percent, the positive sentiment from the report was offset by the reality that the U.K. was the only major country that failed to grow in the third quarter. To the disappointment of policymakers, the country remains mired in recession. Unfortunately based solely upon the October trade numbers and the fourth quarter retail sales reports that we have seen so far, growth may have remained negative in Q4. The outlook for growth is a critical component of the Bank of England’s monetary policy decisions. Tomorrow, we will receive the minutes from this month’s central bank meeting which will indicate how many members favored keeping the Quantitative Easing Program unchanged. If the vote was relatively tight with a good number of monetary policy members voting for additional easing, the pound could come under further selling pressure. However if the vote was unanimous or if the tone of the minutes is slightly hawkish, the pound could easily rise back about 1.60. Aside from the GDP numbers, the current account balance was also released this morning with the deficit expanding marginally in the third quarter.

NZD/USD: GDP MISSES

Broad dollar weakness has pushed the Australian and New Zealand dollars lower but the Canadian dollar continued to buck the trend, rising for the third trading day in a row. Disappointments in both Australian and New Zealand economic data contributed to the underperformance of the Asian currencies. The New Zealand economy expanded by 0.2 percent in the fourth quarter, falling short of the market’s 0.4 percent forecast. For Australia, the Conference Board Leading index turned negative in October, signaling that the recovery in the Australian economy may be slowing. There was no economic data released from Canada but the rise in crude prices and the prospect of stronger GDP numbers tomorrow is helping to lift the CAD. The latest retail sales report indicates that consumer spending remains strong while the trade balance returned to surplus in October. According to Canadian Finance Minister Flaherty, there are no signs of a housing bubble at this time but if a bubble were to develop, he can tighten standards and make mortgages tougher to obtain.

USD/JPY: SIX DAYS OF PERSISTENT STRENGTH

For the sixth trading day in row, the U.S. dollar appreciated against the Japanese Yen, hitting a one month high in the process. In fact, the strength of the currency pair has pulled all of the other Japanese Yen crosses higher. Don’t forget that the reason why currency pairs such as the AUD/JPY are known as crosses is because their rate is dependent upon the value of USD/JPY and the AUD/USD. Japanese economic data also disappointed, which may have added pressure on the Yen. The latest report indicates that supermarket sales have been negative for12 months in a row while small business confidence dropped for the third consecutive month. Unlike large businesses, small companies have not benefitted from the global recovery. The divergence between the Tankan survey which measures the confidence of large businesses and Shoko Chukin report which surveys small businesses reflect Japan’s fundamental problems which is that stronger profitability in the corporate is not filtering into the rest of the economy. According to a Reuters poll, the sentiment amongst Japanese consumers has also fallen for the fourth consecutive month. There are no economic reports due from Japan tomorrow. The latest comment from Bank of Japan Governor Shirakawa that policy guided by short term price moves would destabilize the economy suggests that they have no plans to change monetary policy in term and economic fundamentals certainly support that.

USD/CAD: Currency in Play for Next 24 Hours

he currency in play for the upcoming next hours is USD/CAD. Canadian Monthly GDP data is on tap for tomorrow at 13:30GMT or 8:30AM EST. At the same time, the U.S. will announce Core PCE as well as Personal Spending and Personal income numbers. Shortly thereafter, the U. of Michigan Consumer Confidence and New Home Sales reports will be released at 15:00GMT or 10:00AM EST. Over the past 3 months, USD/CAD has been trapped in a range. The currency pair currently roams within the Range Trading Zone which we determine using Bollinger bands. A lack of trend and decrease in volatility has created an asymmetrical triangle that signals that a breakout is imminent. The upper boundary of the triangle acts as the key resistance level, particularly since it coincides with the 100-day SMA at 1.0680. Meanwhile support lingers at the 1st Standard Deviation which coincides with the bottom boundary of the same formation and the psychologically important 1.05 level.