Look to Intermarket Relationships to Define Direction

Financial markets rarely trade completely in a vacuum. What happens in one market frequently spills over and may drive other markets’ movements. Perhaps nowhere has that been more apparent than in recent trading patterns among major currencies and other key financial markets, such as stocks and commodities

SFO, March 2010

SFO magazine is a terrific resource. It provides free educational materials that help people invest and trade to maximize portfolio return, however, the magazine is not the topic today; it is the above quote from the March issue that provides the fodder for today’s article.

It is hard to imagine anyone in the trading world today that strictly analyzes markets, financial or otherwise, in isolation. The threads of the global, economic community weave their way over, under, in, and out of the sum total of global, economic activity, which makes market-upon-market influence a phenomenon that would be dangerous for traders and investors to ignore. Perhaps the most explicit example of intermarket relationships today is the “U.S. dollar-correlation trade,” which has been the subject of at least two of these columns recently.

This correlation trade has been ongoing for a while; however, lately it has shown signs it might be breaking down. Is it true, as SFO suggests in its current issue, that the dollar-correlation trade is close to reverting to what SFO calls “historically normal levels,” which means much less of a 1:1 correlation? Does it mean that, as a practical matter, the U.S. dollar-correlation trade is over?

Time will tell, as coming economic events will continue to influence the flow of money. Consider this, though – in the month of February, only $5.5 billion flowed into U.S. equity markets (.1% of total assets) and $28.1 billion flowed into bond funds (1.2% of total assets). This allocation suggests a certain risk-averse mentality, which derives from caution about the economic recovery. The February money flow into bonds versus equities translates into lower bond yields, lower values for equity indices, and a stronger U.S. dollar. At least for the month of February, the trade was still in force. March, however, just might tell a different tale.

Arguably, the U.S. economy has found the bottom. If this is true, the dynamic that strengthened the dollar in February could easily dissipate. In March, we have already seen corporations putting an abundance of cash (some $2.3 trillion on the books) to work in mergers and acquisitions (M&A), hefty stock buybacks, and increased dividend payments. This use of liquid cash signals CEOs are re-building their confidence in the economic recovery. Historically, a surge in M&A activity, re-investment back into the company, and a ”thank you” to the shareholders occurs in the trough of the economic cycle, which is one reason why many now argue that we have hit bottom. Counter this with the reality that insider buying rose slightly from January levels but is still at a historically low level. If CEOs are so confident, why don’t we see this confidence reflected in their personal purchases of company stock?

Perhaps, the reasons are that consumer confidence, personal income, and consumer spending all dipped down in the most recent reports. Europe is still struggling with the sovereign debt of Greece, Spain, and Portugal, as well as dwindling confidence in the economic recovery of the EU, and China is tapping the brakes in an effort to slow down the heated pace of its economic growth. Dare I mention our own issues with sovereign debt that are weighing on investors’ minds? As well, above all of this uncertainty hovers the dark cloud of our own unemployment issues. The employment report issued on Friday, although better than expected, still points to an anemic recovery in jobs, which supports the argument that we are in the midst of a slow overall economic recovery. Finally, the big question out there is, when the Fed does raise interest rates and begin the process of exiting quantitative easing, what will the affect be on the economic recovery? Timing is everything, and in this case the concern hinges on whether the Fed can time its actions just right so as not to put the brakes on the recovery before it even gets some traction.

Is all of this uncertainty enough to keep the U.S. dollar-correlation trade alive and well? Again, time will tell, but consider this: the manufacturing sector expanded in February for the seventh consecutive month, and the overall economy grew for the 10th consecutive month according to the latest Manufacturing ISM Report. Even though the numbers are slightly down from January and a viable argument exists that the massive government stimulus skews the numbers, one has to be impressed with the ability of our manufacturing sector to get up off the mat after such a powerful knock down. Add to this the rise in activity in the service sector for February and a case can be made that not going down is equivalent to finding the bottom, which, by the way, is the position many economists now take on the U.S. real-estate market – it has hit bottom. Support for this comes in the recent numbers showing a rise in the U.S. median price of a home, a reduction in the year-over-year foreclosure numbers, and a doubling of the number of people successfully utilizing the government program for restructuring loans to avoid foreclosure.  True, new home sales and sales of existing homes dipped, but new home sales comprise less than 15% of the total real-estate market, and January is traditionally one of the slowest months for all real-estate sales. Keep in mind year-over-year sales numbers are resoundingly better.

Does any of this data mean that the U.S. dollar-correlation trade is over, or does it mean the trade will continue? Who is to say for sure at this point, but one thing we certainly know is that no market trades in a vacuum, and that a solid appreciation for the intertwined nature of today’s global economy and financial markets is necessary for success in these uncertain times.

Best Regards,

Lou Mendelsohn