US Dollar Stronger on Higher US Stocks – Is it normal?

Currency Strength Heatmap (since 2nd Jan 2013)

USD has been strengthening significantly since the turn of the year, gaining against all major currencies except for NZD. This occurred when S&P 500 saw a huge resurgence of bullish buys on the 1st week of Jan, with price continuing to rally without suffering any significant pullback thus far (as seen on chart below). This is interesting considering that USD has generally been regarded as a “safe haven” currency – e.g. negative correlation with stock prices. Hence we should generally expect USD to weaken, and not rally against your conventional “risk currencies” when risk appetite is strong (as proven by stock prices rallying).

S&P 500 Weekly Chart

It is also important to note that this co-relationship wasn’t present when Stock prices were recovering from the Lehman Brother crisis. In fact, USD was falling greatly back then due to strong quantitative easing measures enacted by the Fed, which helped stock prices to recover but push the Greenback lower. So what has changed since then? Not much to be honest. Stock prices are still rallying, while the Fed is still continuing its 3rd round of quantitative easing. So why is USD strengthening now instead of moving lower?

The obvious reason is the fact that market has been talking about QE3 stopping in 2013. As traders are forward looking, cutting QE tap in the future will result in a recovery of USD strength, and it make sense to buy USD now and hold it especially since recent FOMC meeting minutes have indicated that some voting members are in favor of cutting QE within 2013-2014. However, this reason does not explain adequately why USD continue to remain so strong in the month of May despite the latest Fed decision making had Ben Bernanke coming out and say that additional QE on top of what we have right now is possible.

Another reason perhaps would be that global investors are now fully attracted to US stocks right now. In recent years, investors were generally skeptical of the recovery of US stocks, as they were unsure of QE’s effectiveness, wary of any rally to be bull traps in disguise. After 2 full rounds of QE and 1 operational twist later (with 3rd round of QE still onging), it seems that investors are now convinced that QE is the way to go, and that market has recovered (whether that is true fundamentally is another issue). Given the fact that Gold prices have been declining, and bond yields at record lows, the strong uptrend in US stocks now become highly attractive. Couple that with overall pessimism in Europe and China, US stocks stand out with higher alpha gains versus other global stock indices. The inflow of funds into US push USD stronger, which explains where we are right now.

The above would have been the perfect reason, except that volume data from S&P 500 and Dow Jones Industrial actually indicates lower trading volume, not higher. If the assertion above is true, then it would actually mean that only foreign money is sustaining purchases, and that US investors are in fact net-seller for the past few months. What this imply is that current stock rally may not be sustainable in the long run if things remain the same, and we could see strong correction coming in quickly, and USD weakening should that happen.

Whatever the explanation may be, traders of both USD and US Stocks should notice by now that current rally isn’t “the norm”. That is not saying that price will just move lower from here, but traders who may wish to enter long now may wish to consider how comfortable they are entering late in the rally without truly knowing convincingly why prices are where they are right now.

More Links:
GBP/JPY – Pointing lower before BOE Meeting
AUD/USD – Growth in Chinese Imports/Exports continue
NZD/USD – Bearish Breakout Confirmed on Wheeler’s report

This article is for general information purposes only. It is not investment advice or a solution to buy or sell securities. Opinions are the authors; not necessarily that of OANDA Corporation or any of its affiliates, subsidiaries, officers or directors. Leveraged trading is high risk and not suitable for all. You could lose all of your deposited funds.