Can the Dollar and Stocks Trade in the Same Direction?
Optimism regarding stability around current levels encouraged buyers to come back into the market last week, bottom fishing various beaten down stocks. The major U.S indices closed up by over 10%, forming weekly bullish engulfing candlestick formations on various charts. Even though economic stress is still weighing on the economy, affecting different sectors, expectations of a brighter future in the distance are now sending investors back into stocks, trying to grab opportunities at discount prices. To date, analysts are still expecting to see more of a sluggish economy, an economy that will continue to contract until the end of this year and throughout the beginning of next. In addition, unemployment is expected to continue to rise from its current level of 6.1% during the next couple of months, making the current economic slowdown one of the longest and harshest ones since the 70’s.
A lot of important economic data came out last week, among them a GDP result showing that the U.S economy had contracted in the third quarter by 0.3% and a rate cut in the U.S, which brought its fund rate down to 2002’s levels of only 1%. To date the U.S is yielding investors one of the lowest interests among financial investments and according to the Fed, additional rate cuts might not be so far off. With interest differentials of over 4% between the U.S and other economies, traders have become puzzled why the U.S Dollar is gaining strength.
Can the Dollar be rising while stock markets are gaining strength?
When learning basic economics, every novice learns apart from the basics of supply & demand and the Keynes theory, that interest rates affect the different financial securities in various ways. Rising interest rates are good for a currency as it attracts investments due to high yielding interest, but it is bad for the stock market as a rising central rate affects rates within the economy, offering better alternative’s for investors than a risky stock market, while depressing demand as borrowers end up paying higher returns.
Under normal market conditions we would expect to see that as the Fed plays with its rates to control healthy economic growth, dollar and stocks trade in opposite directions. As one goes up for a period of time the other goes down (within their major trends).
If this was the case then trading should seem to be easy, but as other factors, such as:
· Government’s interference among certain economies, preventing a floating rate against the U.S Dollar
· Global economies investing in one another
· Large deficits
· Different levels of inflation and economic growth between economies
Due to these factors among others, things tend to become more complicated, lowering the negative correlation between the two.
Even though the major trend of the Dollar over the last couple of years has been downward, secondary trends have often diverged from stocks trends, despite other affecting factors, when the Fed has changed their monetary policy.
In addition, peaks and troughs of economic cycles also have a mass affect on directions and the correlation of the two, often forcing them both to trade in the same direction. From a negative correlation the Dollar and the Stock market will often turn positive as both of them trade in the same direction. The U.S stock market began to decrease towards the end of 2008, a trend caused by the housing and financial slump, joining a down trend in the U.S Dollar that had intensified, due to expectations of further rate cuts.
To date the Dollar has gained over 20% since June, breaking a major downtrend line, increasing against an array of currency pairs. Traders and investors alike are now fleeing to the U.S Dollar seeking refuge in this unusual safe-haven, on expectations that other economies still have further economic mess to deal with. In addition, investors are now expecting a FIFO (first in first out) situation, in which the U.S will step out of their crisis first, and that current levels on stocks are now pricing in the worst.
Could we yet again see a positive correlation between the Dollar and U.S stocks over the next couple of months, with the Dollar leading the direction?
Even though the Dollar’s trend has obviously changed over the last couple of months one should not get over excited as indicators are pointing to a mild correction that has already taken place. Dollar counterparts are still around oversold levels.
Stock markets made a radical change this week but failed to follow through with impressive candlesticks. This week’s session should give a clearer picture as while investors are becoming slightly optimistic, unemployment results could continue to weigh on investors, restricting bullishness, especially as NFP results are expected to drop and unemployment is expected to come out at a whopping 6.3%.
Technical Analysis
SPY- Daily Chart
*courtesy of stockcharts.com
US Dollar Index- Monthly Chart
*courtesy of netdania.com
VIX- Daily Chart
*courtesy of stockcharts.com
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