Due in part to the expected future path of Fed monetary policy, the old correlations between the S&P and currency valuations do not appear to be working as before.
The old correlations we had become accustomed to over the last few years were based on investor’s appetite for risk and on the currency side, this was expressed in carry trades. When the market was moving into risky investments (stocks), the dollar generally weakened against the higher-yielding acquisition currencies (euro, pound, A$ and K$) as it gained on the yen while at the same time, the higher-yielding acquisition currencies also gained on the yen. The reason for this was because the yen, with its LIBOR rates consistently far below those of other currencies, was the main funding currency- meaning that traders borrowed in yen in order to buy higher-yielding currencies elsewhere.
The biggest profit potential in a carry trade actually lies with the appreciation of the acquisition currency against the funding currency upon repatriation, which may explain why the dollar depreciated against the higher-yielders when the market was buying risk last year.
For example, the price of EUR/JPY is equal to the price of EUR/USD multiplied by the price of USD/JPY (EUR/JPY = EUR/USD x USD/JPY). In this case, investors in a EUR/JPY carry trade would be highly motivated to also buy the euro against the dollar in order to greatly accelerate the appreciation of EUR/JPY. The same situation existed with GBP/JPY, AUD/JPY etc.
Naturally, this all reversed rapidly after the collapse of Lehman Bros. in September 2008. But once the S&P began its steep ascent last March, we didn’t see the correlation hold.
The reason for this can be explained when you look at dollar and yen LIBOR rates over the period. One month dollar LIBOR actually fell below that of 1 month yen LIBOR-a situation that remained in place until about mid-November. In other words, for most of the S&P’s appreciation, it was the dollar that became the main funding currency in carry trades, and it was the dollar that depreciated against all currencies.
Currently, 1 month dollar LIBOR is about 25 basis points (bps) higher than yen LIBOR. So what we likely are to see now is the dollar trend higher against the yen as stocks continue to appreciate (which is what I’m anticipating this quarter).
What we’re unlikely to see is a big move into the higher-yielders vs. the yen, mainly because volatility on those pairs figures to remain high (meaning that price will not move in a smooth upward trend). The reason for this is because of the currently expected path of the Fed’s monetary policy in the second half of the year (somewhat tighter). In other words, it will be much harder to appreciate an acquisition currency like the euro against the yen because there likely will be downward pressure on EUR/USD as long as expectations for a rate increase (or a liquidity tightening by raising the interest rate paid on reserves) by the Fed remains in play.