US Dollar Remains Inversely Linked to Stocks, But Correlations Don’t Hold Forever

Don’t let today’s volatility fool you: the US dollar remains in consolidation mode. The US dollar’s strong open on Sunday was followed by weakness throughout the European and US trading sessions, but for what it’s worth, the Canadian dollar and British pound were really the only currencies to make headway against the greenback. Looking at the data on hand today, a surprising 1.3 percent surge in industrial production for the month of October was offset by a drop in the New York Fed's Empire Manufacturing index to a record low of -25.4 in November. Meanwhile, Citigroup announced that the bank will eliminate 52,000 jobs over the next year, representing roughly 15 percent of the firm’s workforce. This is a large amount by every measure, and with the US unemployment rate already at a 14-year high of 6.5 percent and climbing, it is clear that downside risks for economic growth loom large.

That said, US fundamentals have had little bearing on US dollar price action given the solid correlation between EUR/USD and the Dow Jones Industrial Average. Indeed, in recent weeks it has been more useful to look at economic releases, watch for their impact on the stock markets, and subsequently trade the US dollar accordingly. The issue is that the market remains risk averse, as investor confidence remains low while banks remain concerned about counterparty risk. True, overnight interest rates have fallen significantly over the past few weeks, but conditions remain treacherous. In fact, Moody’s reported that the number of companies with low liquidity have reached the highest level since 2002 in October. This suggests that the lack of credit availability is taking a toll on everything ranging from banks to businesses to consumers, and until these conditions improve they will remain a burden on investor sentiment going forward.

Looking ahead to Tuesday, the release of the US Producer Price Index shouldn’t have a huge impact on the greenback, as the markets are already well-aware that inflation pressures are cooling dramatically. As a result, traders may be better off keeping an eye on risk trends. It is also worth keeping in mind, though, that correlations have a tendency to fall apart once everyone catches wind of it. A quick search of wsj.com shows at least two articles discussing the link between stocks and EUR/USD, signaling that traders should stay on their toes as the correlation could easily break down.

British Pound Gains on Technical Retracements, Downside Risks Remain

The British pound surged higher on Monday versus the US dollar and Japanese yen, but the move was more of a technical retracement than a fundamentally charged move. Indeed, economic data was downright dismal, but since the currency has plunged over 13 percent versus the greenback during the past month – the most of the major currencies we follow – it is prone to sharp reversals. Likewise, the pound has been exceptionally weak against the euro, as it has fallen to the lowest levels since the inception of the European currency. Looking at the data on hand, Rightmove house prices plummeted for the fifth straight month by 7.1 percent in November from a year earlier, marking the sharpest decline since recordkeeping began in 2002. On Tuesday, UK CPI will be released and should reflect softer inflation pressures, as the annual rate is anticipated to slip to 4.8 percent in October from 5.2 percent. However, due to the plunge in commodities and waning domestic demand in the UK, there is some downside risk for this particular report, especially since the Bank of England has said that they believe the index will eventually fall “well below” their 2 percent in 2009. As a result, there is potential for this CPI release to weigh on the British pound on Tuesday morning, though its impact may be lessened as the BOE and the markets are more concerned about growth prospects for the region.

Euro Holds Within Range - Imminent Breakout?

On Friday night we noticed a sharp shift in risk appetite and noted that it didn’t bode well for EUR/USD on Sunday’s open. The pair did indeed fall sharply, as the G20 meeting over the weekend didn’t yield any comments that inspired confidence in the markets. However, EUR/USD eventually climbed higher throughout the European and US trading sessions as most of the major currencies remain in consolidation mode. Overall, the trend is still bearish for the pair and I think a breakout to the downside could be imminent, which is why I chose “short EUR/USD” as my analyst pick of the week. Indeed, there is little in the way of Euro-zone economic data scheduled to be released this week, leaving EUR/USD likely to be driven by risk trends.

Japanese Yen Slips as Japan’s Economy Falls into Recession for First Time Since 2001

The Japanese yen has traded very choppily lately, but remains below its October 24 highs where the low-yielding currency ran into critical resistance versus most of the majors. One of the key tools to gauge the consistency of the trend for the Japanese yen has been the US stock markets, and the inverse correlation between the Dow and the yen (and US dollar) has been something we’ve been noting frequently. We don’t focus on Japanese fundamentals very often because of this correlation, but it is certainly worth noting the disappointing Japanese GDP figures for Q3. Japan's economy, the second largest in the world, fell into recession for the first time since 2001 as GDP fell an annualized 0.4 percent in Q3. This was the second consecutive contraction, and with a global economic slowdown impairing demand for foreign goods, this export-dependent nation will likely feel the pain. Nevertheless, the Japanese yen still has bullish potential as volatility remains high, leaving risk aversion in play.

Terri Belkas is a Currency Strategist at FXCM.