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.
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