US Dollar Decoupling: Flight To Safety No More?

A lot has been made about the “flight to safety” and risk aversion trade in the currency markets. That is, whenever there is some sort of negative economic news or global crisis, money comes pouring back into the US dollar. So when things are going well and equity markets, both here and abroad are going up, the US dollar is expected to go down.

This always struck me a sort of funny; after all it was the all the economic bad behavior here in the US which has caused the global crisis. But nevertheless, that’s just the way it’s been.

The correlations have been in place and investor psychology is such that if traders believe that the US dollar is the safest place to be when the stuff hits the fan, who am I to argue?

That’s why Friday’s market action after the Non-Farm Payrolls report struck me as rather odd. Both the equity markets AND the US dollar gained as the S&P 500 index ETF (SPY) and the Powershares US Dollar Index Bullish (UUP) were up 1.3% on the day.   So what’s going on here? Let’s have a look.   Market correlations are important and they usually work great…. until they don’t.

There are a few possible reasons why Friday’s NFP report sent both the US dollar and the equity markets moving in the same direction.

The first reason is that the dollar may be acting more on the fundamentals rather than the correlations. The Friday NFP report was seemingly “good news” as the equity markets responded positively so this could mean a decoupling for the dollar from the flight to safety trade. Treasuries responded sharply to the news with 10-year yields surging 10 basis points to 3.854%. This could signal a turn-around in the dollar, as the data is showing that the economic contraction is slowing.

Also, this Wednesday, the FOMC meeting on interest rates will take place and the Fed is expected to leave rates unchanged. However, it may signal that its policy of buying Treasuries may be coming to an end if that data points to economic recovery, which would bode well for US dollar strength.

Should this occur and the dollar retains its “safe haven” status, then this could loom large for equity and oil markets. Because oil is denominated in US dollars, it tends to trade inversely to the dollar. Or we may just see the dollar/stock market correlation break down.

Either way, be prepared for some potential volatility and remember to trade what you see and not what you think you know.  I’ve seen more than one trader lose big when a correlation he thought was iron-clad de-coupled. And last Friday’s action may be a sign that this about to be the case.

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