From the desk of Steven Strazza @Sstrazza and Ian Culley @IanCulley
Correlations often work... until they don’t. It’s just the nature of intermarket relationships.
We can see a prime example in the recent action between the US dollar and risk assets.
The dollar has been marching to the beat of its own drum, as it's shown an unusually strong positive correlation with commodities since this summer.
Although the inverse correlation is not as strong with equities, it still exists. But the USD’s resilience during the second half of this year hasn’t stopped stocks from screaming higher.
While we definitely aren’t in an environment where USD weakness is a tailwind, the evidence continues to stack up in favor of the bulls and risk assets.
The dollar is just one data point. But it’s a rather important one, as the direction of King Dollar has proven to have a profound impact on other asset classes.
Today, we’re going to highlight the decoupling of USD relationships and what it could mean for the rally in risk assets.
Let’s dive in!
Here’s the AUD/JPY cross overlaid with the US Dollar Index $DXY along with a correlation study at the bottom:
The AUD/JPY is one of our favorite risk-on barometers, often moving in the same direction as stocks and commodities. On the flip side, DXY trending higher tends to be a sign that investors are reducing their exposure to risk by fleeing those same areas.
The risk-on versus risk-off tone of these two markets is illustrated by the strong inverse correlation in the bottom pane.
If we were to zoom out and show this correlation, it would look very similar throughout history. It’s completely normal for the relationship to decouple and these two charts to trend in the same direction. It’s also normal for these periods to pass and for the relationship to revert back to its historical tendency.
This is merely a divergence in the standard intermarket relationship. And, if history is any guide, it’s likely temporary.
Could both the AUD/JPY and DXY continue to trend higher?
Of course. Anything is possible.
But it’s not the bet we want to make. Especially not over any meaningful timeframe.
Risk assets are on the rise, and cyclical areas of the market are trending. Many charts look similar to AUD/JPY, fighting to reclaim highs from earlier this year after an extended period of consolidation.
With that as our backdrop, it’s hard not to lean in the direction of the USD rolling over and these intermarket relationships returning to their historical norms. If we’re making the bet that USD continues higher and risk assets roll over, we’re betting that many more charts are also likely to fail at their former highs.
Large-caps. Small-caps. International indexes. Crude oil. Copper. The list goes far beyond AUD/JPY.
The other option is we see the dollar roll over here while the breakouts in risk assets remain valid.
We think that's a much safer bet. When we weigh the evidence, the bulls enjoy a laundry list of new highs and risk-on developments. Outside the more tactical data points, all the bears have to hang their hats on is a strong dollar.
That doesn’t mean we expect everything to fall in place tomorrow, next week, or even next month. The message from the currency markets is patience. Mixed signals abound.
Over the long run, we think risk assets will continue to rally… and a strong dollar isn’t likely to last in that environment.
Stay tuned! We’ll continue to keep you updated on key developments for the US dollar index.
Thanks for reading. As always, let us know what you think.
And be sure to download this week’s Currency Report!
