By DJ FX Trader
As crude-oil futures spiked through $100 a barrel Wednesday, they left behind two partners that had previously accompanied them on such rallies: the euro and the Australian dollar.
It’s early days, but some see moves like this one–or non-moves, as was the case for the stagnating Aussie dollar and European currency–as a sign that a once iron-clad correlation between crude and high-yielding growth currencies is breaking down.
In that previous relationship, a perpetually falling dollar was associated with a range of “risk-on” strategies. These included buying gold, silver and other commodities, or investing in currencies that are typically sensitive to global economic growth trends, or, for a while, piling into U.S. stocks. For some, the rationale was that the U.S. Federal Reserve’s aggressive “quantitative easing” bond purchases, or QE2, was depleting the dollar’s value and forcing investors to seek out “hard assets” and growth-sensitive currencies such as the Australian dollar and the euro that could function as a hedge against inflation. But for others, it became a kneejerk binary reaction based on the simple observation that one thing was leading another. That approach was doomed to break down eventually.
Once oil and other commodity prices rose so high that they were met with a wave of selling earlier this month, a sharp unwind of those negative-dollar bets ensued, putting the same relationship into reverse. Now that this move has more or less played out–marked by oil’s rebound Wednesday–many investors feel such simple rules of thumb are no longer applicable. That has left traders in different markets struggling to find clear direction.
In foreign exchange, it means traders are distinguishing between those currencies with a legitimate tie to commodities and those without it.
“Some currencies will always have a strong connection to commodities, like the Australian dollar, but the euro’s relationship to commodities is much more indirect,” said Jens Nordvig, head of G-10 foreign exchange strategy at Nomura Securities in New York, noting that its correlation to oil seems unanchored.
Other factors come into play for the euro, most importantly a renewed focus on the euro zone debt crisis, which has lately weighed on the single currency. However, factors that underpinned its earlier gain against the dollar in tandem with oil are still in place, creating a somewhat confusing set of trading signals. In particular, despite the drop in commodity prices, inflation risks from high food and energy prices remain, which was seen driving the European Central Bank to keep raising rates, a euro-supportive trend.
Notably, the euro’s flat performance Wednesday coincided with the release of minutes from the U.S. Federal Open Market Committee’s late April meeting in which it offered few signs that it is about to tighten monetary policy soon. That should have reinforced a dollar-negative contrast with the ECB’s apparent tightening bias.
Amid these conflicting signals, it’s almost certainly too early to predict a new correlation to replace the old risk-on/commodity one, Nomura’s Nordvig said. The currency market is almost certainly in a “consolidation” phase as it waits for the old trend to possibly pass, he said, following last week’s “correction” and major sell-off in commodities.
For that reason, his bank is advising a trade where investors bet on the euro moving within the tight band of $1.37 to $1.47 for the next two months.
And this consolidation phase could last awhile. The vestiges of the old correlation will need to fade first, and in terms of the historical data it is still very much imbedded into statistical measures of the relationship.
According to market data compiled by Dow Jones Newswires, there is a 85% correlation over a 30-day timeframe between front-month crude contracts and the euro-dollar pair. That’s a remarkably strong relationship for a pair that has not traditionally been so closely aligned.
But when measured over the last five days, that correlation has gone sharply negative, to minus-36%. That could suggest that a lasting break is underway.
Confusing matters, traders are watching other correlations too, some of which have also been extremely volatile. A 30-day correlation of 62% for euro-dollar against the S&P 500 stock index has become minus-1% over the past five days.
With this change, equities investors who had been treating the falling dollar as an auto-pilot signal to buy the stock of companies in energy, materials and broader commodities sectors are now expected to become more choosy. “People are reallocating to under-appreciated assets like financials and staples,” said Jamie Cox, managing partner of Harris Financial Group. “It’s a rotation more than anything.”
Foreign exchange traders, who must try to determine dominant new themes that tend to wax and wane over time, won’t have it so easy. For them, the direction could be hard to ascertain for a while.
But if we are at the beginning of a new cycle, Douglas Horlick, head of FX institutional sales at Bank of America Merrill Lynch in New York advises looking to the U.S. economic outlook for future clues.
“It’s all about the dollar,” said Horlick. “The dollar is going to benefit if we see a correction in the S&P and it likely benefits if we get our fiscal house in order,” in the U.S., he said.
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