Its been “the” inverse correlation which has driven black box trading systems, hedge strategies, risk on and risk management trading systems of the last few years.
Very simply as the dollar index declined asset prices rose, especially those assets priced in USDs ie commodities. Every correlation and inverse correlation must have some logical basis to support the moves. The inverse correlation was explained by the weight of the FED’s actions vs other fiat currency central banks actions. The FED employed a debasement strategy of the USD vs other fiat currencies to support US exports in an attempt to re balance the US economy away from a purely consumption model towards a more balanced produce and consume model. The FED’s strategy was to dump USD liquidity on participants to enable us to borrow USD’s at zero interest rates. This allowed us to purchase yielding and capital appreciating assets whilst funding costs were essentially zero. For a few years, at least, this has been a profitable venture.
The strategy worked on the basis that the USD would be the funding currency. Ie that other central banks would not match or out match the FED’s easing actions. The perfect one way trade was in play.. ie borrowing USDs and purchasing appreciating foreign denominated assets allowed the perfect scenario of capital growth, yield, zero interest rates whilst the liability of the funding currency declined in value.
http://www.financialsense.com/contributors/jason-kaspar/can-dollar-weakness-mean-equity-weakness
The question looking ahead is why is the inverse correlation breaking down? Should we be worried and what next?
Firstly, why is it breaking down?
The DX (dollar index) is a construct of the USD vs the EUR, GBP, JPY, CHF, AUD, CAD (in this order).
Its become very clear that the debt and structural issues that the US faces are not simply confined to the US. The eurozone, Britain and Japan all face very similar issues. Therefore borrowing USDs to purchase euro assets and expecting these euro assets to both rise in value in addition to the euro rising in value to the USD has become an unlikely event. Participants have, en mass, discovered that euro liquidity (money printing) is very likely to equal that of the fed on a relative basis. And that this is equally true to the GBP and JPY areas. As each one of these relationships falls over expect equity waves of equity weakness due to the USD being relinquished as a funding currency to be replaced by GBPs Euros and whatever else.
At this point I’d just like to take a small step back and provide a little monetary and economic theory for those with appetite to explain these issues in more detail.
Austrain theory (and indeed ‘common sense’) tells us that demand stalls at each progressive sequence of price rises. Ie as prices rise, due to money debasement, the real economy struggles to absorb the waves of price increases. (We can see this occurring right now all around us). This strangles demand and the gdp stalls. So, as GCSE students should know, this marks the start of the super inflationary cycle or a deflation wave depending on actions taken. I.e. if central banker’s print demand is sustained at the new price level gdp rise, money is debased, prices will rise so that demand will soon be threatened again and central banks will have to sustain prices and the newly inflated levels or face deflation. This is all text book stuff and frankly almost boring as its so straight forward. Bernake et al are all well aware of these issues, imo. Bernake also knows that money supply (and therefore inflation) can be embedded in a system without the very transparent need for central bank money printing ie QE. The banking system must be the enabler for sustained inflation (or money debasement) and therefore new co banks and other bank supportive measures inc ‘sale and lease back’ programs must be enacted. Only when we see these programs truely adopted en mass will we have a self sustaining super inflationary cycle. This will be the signal to go all in with leverage and ‘bet the farm’ on inflation.(For long term followers of this website and prior boards two v.important words for you, subject to ‘historic vol’ allowing the entry, OPTION CALLS!) All the central banks in the west are working to the end (have no fear) of implementing self sustaining super inflation but none are there yet. Until we see the strategies enacted meaningfully we will continue to see high 70s style volatility (albeit, imo, with nominal higher highs and lower lows).
Theory over, back to the DX.
The key point to take away is that the net money supply effect is short term negative as dollars are repatriated by participants but this deleveraging process is simply being replaced by central bank money printing. So we have a short term debt purge by financial participants as the DX inverse breaks down.
Where next? What follows after this temporary US deleveraging ceases..? The key inverse correlation is not, imo, the DX to assets. The key correlation is money supply to asset prices. I cannot chart this adequately at present but if you could i have a strong feeling that money supply due to central actions is exploding and that we actually dont need a chart to see this. If we took euro, gbp and jpy with the USD money supply and charted her vs asset prices i know instinctively what this chart looks like. The money supply is exploding upwards, once again, enabling demand at the new price levels and so attempting to embed inflation in the system. There is a short term deleveraging of USDs but this can and will very quickly be replaced by other finding currencies. Assets will rise as fiat money is lent and expanded.
The summary is all (developed) fiat money vs asset prices will continue to lose value in concert vs assets, inc equity prices but ex government bonds. That, it is always necessary to look beneath the volatility of ‘near term’ market prices to unpick the key fundamental issues that will drive prices and trends of tomorrow. Only this sort of analysis will provide the back bone to support trading and investing strategies as short term deviations from long term trends and issues unsettle you.
I strongly believe that the DX debasement inverse correlation was a short term indicator within an overall process of fiat money debasement. This is simply all she was, nothing more. The DX inverse correlation was a chapter within an unfolding story with many twists and turns as participants understanding develops. The general fiat debasement continues unabated and assets with high earnings ratios are an opportunity for asset allocation at this time. (Recognizing that volatility will persist until inflation becomes truely embedded through the banking system rather than QE programs).
Rich
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