Markets have always maintained correlations based on shared fundamentals and competing investors. The most talked about correlation in recent market history was cemented in 2009 between asset class markets, currencies, and commodities by QE I in 2009, and QE II in the fall of 2010. By dropping interest rates to near zero and allowing banks to exchange non-performing loans for U.S. dollars, and refinance their debt at more favorable interest rates, the U.S. Federal Reserve back-stopped a potential melt-down of the global finanial system. Bankers took the flood of Greenbacks and invested them in asset class markets such as dividend yielding blue chips stocks like the S&P 500, carry currencies such as the Australian dollar, and demand or momentum driven commodities such as crude oil, and gold and silver. The flood of U.S. Dollars into the market on behalf of the U.S. Treasury at the behest of the U.S. Fed also benefited the value of the euro by default. In today’s highly coordinated financial market more dollar supply means less demand which by defaults puts a bid in the euro. This secondary effect of a stronger euro was a positive for European bankers as it helped insure that their outstanding loans would not be paid back in a devalued currency. This was a very real benefit because while U.S. bankers were able to transfer their problem holdings to the public sector, i.e.: the U.S. Fed, European bankers were not so lucky. Hard for European business’ to complain about an unfair currency advantage created by the Q.E.’s when their primary concern was living to the end of another quarter. While the dollar continued to retreat because of the increasing supply of dollars coming off the U.S. Treasury’s press, household wealth in the form of the stock market and U.S. Treasuries held up and actually increased, while European bankers caught a break to their bottom line from a stronger euro. The collateral damage from the Fed’s operations may have manufactured inflation thru pseudo commodity demand – hedge funds and their clients weren’t complaining -- yet the ends in the eyes of the Fed: supporting asset class markets and household wealth following the implosion of a housing bubble, justified the means. The Fed planned to support asset class markets such as blue chip stocks and the residual effect was that other asset class markets such as the Aussie dollar benefited, as did currencies with no real carry such as the euro and pound, along with the more speculative commodity markets.
While economists and market pundits were taking a potential QE III for granted just two months ago, it is looking more and more likely that this won’t happen. Despite the European banking crisis, and slowing global growth, U.S. GDP is growing again. And asset class markets -- markets that have a dividend or real yield – are holding their own. But what about currencies with no real yield, and outright speculative vehicles such as commodities where the speculator actually pays the carry charge? Clearly the correlations that speculators in these markets profited from over the past couple of years are waning. Nothing makes that more clear than looking at the performance of a handful of markets since the first trading day of October.
S&P 500 +12%
Australian Dollar +5.2%
Gold -1.0%
Euro -1.3%
Even more striking is the poor performance of many hedge funds who are reported to be experts in currency and commodity trading. Not this year. One of Wall Street’s leading hedge fund traders, John Paulson, who counts Alan Greenspan on his advisory board, was reported to be down over 44% on the year in his Advantage Plus fund as of November. “…Our assumptions proved overly optimistic and net equity exposure too great”, he was reported to have written to shareholders. It may be simpler to say his overly pessimistic economic assumptions were wrong. While hedge fund traders and their investors may have benefited from the hard times in 2009 and 2010, to quote Bob Dylan, “the times, they are a changin’”, and so are market correlations.
Such powerful connections between markets do not just fall away overnight. In fact they actually still hold up pretty tightly on a short-term basis. The markets still all twist and turn at the same time, some just move further and faster than others. Today for example saw both the Australian dollar and the euro lower but with the euro down more than .06% than the Aussie.
The question is what does the breakdown of these correlations mean for market direction going forward? We have to remember what are the Fed and Treasuries objective? They are protecting U.S. household wealth, while trying to foster job growth. Given they have done what they can to help the market by sanitizing the debt of the biggest players, it seems unlikely they will do that again, or even if there is a need for it. It likely does not mean we won’t see cyclical slow-downs, even bear markets going forward for asset class markets. We will. But it probably means future downturns wont’ be as severe given banks and investment houses have been given ample opportunity to get their houses in order and refinance at much lower rates. It also means that it is much more unlikely to see rallies in markets where speculators have to pay the cost of carry and storage such as in commodities which aren’t consumed, i.e. silver and gold; or currencies with little or no yield in areas of the globe with unfavorable demographics, like Europe.
To see Jay Norris point out trade set-ups and signals in live markets during both U.S. day and evening sessions go to Live Market Analysis . Jay is Chief Market Strategist at IBTRADE, and the author of Mastering the Currency Market, McGraw-Hill, 2009 and Mastering Trade Selection and Management, McGraw-Hill, 2011
