Dollar is the new euro; reaction to Fed underlines shift in FX market
The response in the FX market to the more upbeat tone from the Federal Reserve points to the sea-change that has seen fundamentals take over as the driving force behind moves in the dollar.
Simply put, as EuromoneyFXNews pointed out last week, it appears there has been a paradigm shift in which the bull trend in the dollar is not merely a function of safe-haven flows. Instead, the dollar reacted positively to the Fed’s positive tweak to its outlook on Tuesday, echoing a similar move earlier in the session after better-than-expected US retail sales figures and also the response to Friday’s encouraging employment report.
The dollar has, for now at least, transformed into a growth currency.
Dollar loses negative correlation with stocks
|Source: Nomura, Bloomberg|
This is a marked change to the regime that has ruled the market since the emergence of the financial crisis in 2007, in which the dollar has been inversely correlated with risky assets.
The dollar was only able to make gains during periods of heightened risk aversion and tension in dollar funding markets, as seen in late 2008, in the second quarter of 2010 and the first half of 2011.
The "old" dollar regime
|Source: Nomura, Bloomberg|
Against the euro, it looks like the dollar has a good chance of breaking free of the old regime and start trading in a more healthy fashion – less negatively correlated to risky assets and more prone to rise on improving US economic data.
This is because, as EuromoneyFXNews has discussed previously, the actions of the European Central Bank have turned the euro into the new dollar. By flooding the market with euro liquidity through its two long-term refinancing operations, the central bank has effectively provided the market with a new funding currency.
However, elsewhere, it is more difficult to categorically state that the price action of the past few weeks represents a structural change in the way the dollar trades globally.
As Jens Nordvig, head of currency research at Nomura, points out, it seems premature to call for a regime shift unless people believe that the Fed’s outlook on rates has changed materially.
Indeed, the last time the dollar shed its negative correlation with the S&P was in 2008, when there was a temporary shift towards expectations for Fed tightening.
“Since the Fed has anchored short-rate expectations to some degree to 2014, it is unlikely we will get a material shift in two-year rates any time soon,” says Nordvig.
That does not mean, however, that the dollar cannot continue to trade with a positive correlation to risk and US growth prospects for the next couple of months.
That is because expectations for US growth were so low at the start of the year – 79% of investors were expecting the Fed to implement QE3 in 2012, according to Nomura.
“The very low starting point of expectations in early 2012, and the remaining potential for upside surprises relative to still fairly moderate expectations, leaves potential to some upward repricing of forward rates, and hence more healthy trading dynamics for the dollar, including potentially more positive co-movement with risk assets,” says Nordvig.
The test is likely to come in the second quarter as the threshold for US data beating expectations becomes higher and the Fed will have to show its hand over whether it believes that further monetary expansion is off the table.
In the meantime, there should be plenty of time to take advantage of the dollar’s transformation in the next couple of months, with further gains a distinct possibility.