Forex Blog - Market Correlations Weaken, A New Normal
Weaken, A New Normal
Running the risk of
beating a dead horse, the more the global economy normalizes the more the
distribution of economic outcomes normalizes the less markets will blindly
trade risk-on/risk-off. So having days where many in the market are
casually assigning causality to the move in gold above $1000 and the decline in
the USD index to a 12-month low as the start of a debt, currency crisis are
signs of normalization, even if grossly off the mark. Just look at US
Treasuries and equitiesâ€¦the day a crisis in confidence in US economic policy
starts, the dollar decline will not happen independently of Treasuries and
equitiesâ€¦sell all. For the gold bugs where reality is an inconvenience,
as long as China targets its currency to the USD to support a massive bilateral
,trade surplus by definition it will accumulate more dollars than it can sellâ€¦hedging
for this monster is at the margins. China can pressure the USD lower, but
China will not unleash a run on the USDâ€¦Asia generally is a net USD accumulator
in periods of USD weakness for the very reason it manages exchange ratesâ€¦Korea,
Taiwan, Thailand are all buying USD in this decline. Look at the US
Treasury $70bln auction this week â€“ demand from indirect bidders (mainly
foreign central banks) was solid.
Equally significant is the
tired state of affairs of the risk-on/risk-off narrative for (explaining)
pricing of assets and FX. The dollar is down on reduced risk aversion say
many analysts. Just look at the rally in commodities, equities, EM FX and
any major currency with a nominal yield advantageâ€¦risk trade is on. But
the yen is up versus the USD and EUR. Wasnâ€™t the JPY the risk-off
currency of the last 18 months? And the yen and A-shares perfect inverse
correlation has vanished too.
At market inflexion points
competing narratives, hackneyed narratives and the emergence of fringe views in
the mainstream are part of the process of transitioning to a new normal.
This applies to currencies, equities and fixed income. The dollar has
broken key levels and there is some momentum building which suggests good
downside ahead for USD index, upside in EURUSD and downside in USDJPY.
But NZDUSD and AUDUSD are vastly overbought (unless you think the price of milk
and lamb products are forever going higher). AUD has a robust China
recovery priced, higher rates from the RBA priced, and maybe even an elevated
risk of a run on the USD priced. Just buying AUD and NZD because they are
going up is not a wise approach in the new normal. I suspect the RBA is
an active USD buyer now and despite the RBNZâ€™s Bollard telling local radio show
he does not think there is much that the Bank can do to check the rise in the
NZD, we donâ€™t have to go back too far in time to see open currency intervention
from this central bank. I am not suggesting a AUD and NZD downtrend lie
ahead, just decent correction is dueâ€¦and making the point that a new normal
requires a more thoughtful approach to trading.
What is the new
normal? One where traders and investors have to do their homework.
One canâ€™t buy anything not nailed down. And one should not assume that
the new normal is just like the old normal. Governmentâ€™s visible hand is
in the mix of capital markets and has a front row seat in the real economy
which has serious implications for asset prices, risk, leverage, bubbles and
moral hazard. If I had to ascribe this implication in one word it would
be volatilityâ€¦despite its best intention of reducing volatility, the presence
of government in markets and the real economy will make for more not less
volatility in asset prices, commodities and FX.
I also get the sense that
many in the market failed to get the G20 central bank memo last weekend.
Markets are well ahead of central banks on when the latter will start exiting
unconventional (and conventional) monetary policy accommodation. This
applies to the RBA as wellâ€¦though it has been most fiercely emphasized by the
Fed and ECB (even Fed inflation hawks or district presidents are on board this
Which leads me to another
sign of a new normal unfoldingâ€¦the inflation debate. This one I find most
amusingâ€¦gold bugs on TV seem to have found their strideâ€¦all this monetary
accommodation means prices are heading upâ€¦look at commodities and look at gold
especially. Why is this not a deflation trade? Is not gold a hedge
against deflation as well as inflation? Does anyone think debt
monetization by the Fed or BOE is a guarantee for higher inflation when banks
are not creating creditâ€¦not lendingâ€¦and when households and firms are paying
down debt? Beware of demagogues. Beware of economic dogma and
especially political economic dogma. And the bid in commodity prices
seems to be a function of China buying natural resources and building gold
reserves from a miniscule share of overall reserves â€“ it will always be
miniscule when FX reserves are $2trln and growing).
Finally letâ€™s not casually
attribute causality to the decline in the USDâ€¦this is not the beginning of the
end of the USD as the worldâ€™s reserve currencyâ€¦not unless you are 50 miles up
and the view is the next 100 years. There is momentum in a lower dollar
and it is worth playing from the short side in the next few weeksâ€¦but some FX
longs like CAD and GBP seem more appropriate than tired AUD, NZD longs.
And if the new normal is
emerging, markets should also prepare for the day when stronger US
fundamentals, even if questionable beyond a few quarters, should start
providing a reason to check the selling of dollars and perhaps start providing
a reason to buy dollars. If Fed balance sheet expansion ends at the end
of October as plannedâ€¦we could be due for a mighty bounce in USD this
fall. That said with the Fed underwriting the mortgage market
(securitization) it is reasonable to ask of this role can end in another 6
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