Thursday's Warning Signal

Thursday's global markets trade showed a very unusual divergence. Global equities markets usually set the direction and pace of commodity and currency markets. Yet on Thursday, while stocks went up, commodities and currency pairs that rise with them generally went down.

Perhaps its just an aberration, though seeing BOTH currencies and commodities resist stocks is very unusual. It is possible that this highly unusual divergence suggests the global equities rally is exhausted.

For those not familiar with the relationships between stocks, commodities, and currencies markets, see below the table for background.

Market Summary Table: Risk vs. Safety Sentiment

[1] Actual ask price for currencies, futures contract prices for stock indexes, commodities. Direction and prices are at time of writing, 6am GMT

Background (Experienced FX traders can skip this)

In general, throughout most of the current world economic crisis, stocks have set the direction for currency and commodity trading. In other words, when stock markets rise (and they generally move roughly together worldwide, so do commodities.

The relationship is logical, because economic expansion (or lack of contraction) implies demand for commodities used for industry, and also implies a greater likelihood of inflation, which spurs demand for inflation hedges like precious metals such as like gold and silver.

Leaving aside the exact reasons why, there are also certain currencies that rise with stocks, called risk currencies, because they are in demand when traders feel optimistic about growth and want to take greater risks to achieve greater rewards. These include the AUD, NZD, CAD.

There are other currencies that tend to move in the opposite direction of stocks and commodities, called safety or safe-haven currencies, which tend to be in demand when markets are scared and traders seek a safe place to put their capital. These include the JPY, the USD, and the CHF.

Safety-Risk Currency Scale

IN GENERAL, THE MOST HIGHLY CORELATED TO STOCKS AND COMMODITIES TO THE LEFT, THE LEAST (MOVES IN THE OPPOSITE DIRECTION) TO THE LEFT

SAFE HAVEN RISKIEST
[moves inversely with stocks] [moves in same direction]

US Treasury Bonds Other Safe Debt Commodities
JPY, USD, CHF, GBP, EUR, CAD, NZD, AUD

Because you must pay for one currency with another, currencies always trade in pairs. When you buy a currency pair, you buy the currency to the left of the "/" and pay for it by selling the one on the right.

For example, if you buy the EUR/USD, you are buying EUR and selling USD to fund the purchase. To exit the trade, you need to sell EUR and buy USD, so when you buy or "go long" this pair, you bet that the EUR will go up in value compared to the USD, If you sell this pair, you're betting on the opposite happening.

Thus when traders believe the economy is growing, not only do they buy stocks and commodities, they also buy currency pairs that go up with these assets. The most popular "optimism" or "risk" currency pairs to buy include: EURUSD, GBPUSD, USDJPY, AUDUSD, AUDJPY. When these go up, it means traders are optimistic about growth and want to take greater risk to get greater return. When these and others like them go down, it means traders are selling these pairs, suggesting greater fear or risk-aversion.

Similarly, when USD/CAD go up, it suggests traders are seeking safety and avoiding risk. When it drops, traders feel good about growth prospects.

Conclusion

Traders should be on guard for a coming pullback in stocks and commodities.
Alternatives include:

Selling EUR/USD, USD/JPY, AUD/USD, NZD/USD, crude, gold, or other commodities.

If you can't trade the actual commodity or currency (generally a better way to play the movement)

Selling the following currency ETFs: For the AUD:(FXA), For the GBP:(FXB), For the CAD:(FXC), For the EUR: (FXE), Shorts the USD (thus selling it is long the USD): (UDN), (CYN), (CYB), (DBV),

Buying the following currency ETFs: Long USD:(UDN), Long JPY:(YCL), 2x Short EUR (EUO)

Selling the following commodity ETFs: USO, OIH, GLD, SLV

Disclaimer/Disclosure: The author may hold positions in the above instruments.

Comments

[Joseph L. S...:]

When you traveled overland in the early days of the Old West and you saw a smoke signal, it was reason to be cautious. When you saw another it was time to unholster the saddle rifle. Cliff, you have provided yet another here for those with eyes willing to see. Forewarned is forearmed.

Aug 21 11:08 AM

[CCRider:]

Isn't UDN a Bear fund betting against the Dollar Index (Short)?

Aug 21 11:30 AM

[CCRider:]

This is not to diminish this article, just point out the error so others can benefit. Like lots of others on this site I believe the market is being propped up and I am betting on a painful fall.

Aug 21 11:37 AM

[ur2smrt4me:]

yes! UUP is what you want if you believe the dollar will go UP

On Aug 21 11:30 AM CCRider wrote:

> Isn't UDN a Bear fund betting against the Dollar Index (Short)?

Aug 22 01:10 AM

[Cliff Wachtel:]

Yes, that was the point. Stocks rising, yet commodities and currencies that tend to follow stocks did not. That's called a negative divergence, because it hints that the risk appetite fueling stocks' drive up may be fading. Apologies if that wasn't made clear enough. Thanks, Cliff


On Aug 21 11:37 AM CCRider wrote:

> This is not to diminish this article, just point out the error so
> others can benefit. Like lots of others on this site I believe the
> market is being propped up and I am betting on a painful fall.

Aug 23 05:38 AM

[Cliff Wachtel:]

Thanks for your kind comments, all the more flattering from a writer who I follow and admire. Cliff


On Aug 21 11:08 AM Joseph L. Shaefer wrote:

> When you traveled overland in the early days of the Old West and
> you saw a smoke signal, it was reason to be cautious. When you saw
> another it was time to unholster the saddle rifle. Cliff, you have
> provided yet another here for those with eyes willing to see. Forewarned
> is forearmed.

Aug 23 05:38 AM