Will FX Catch Up To Stocks Or Vice Versa?

Includes: FXA, FXE, UDN, UUP
by: Kathy Lien

FX and Stocks - What Does the Divergence Tell Us?

Currencies and equities are moving in completely opposite directions.

The stock market has performed extremely well this month with the S&P 500 rising to its highest levels in 4 months. Currencies on the other hand are struggling with the EUR/USD trapped in a range for the past week and the AUD/USD rolling over.

Better-than-expected corporate earnings and Apple's (NASDAQ:AAPL) new product releases have made equity traders excited, but stocks are trading like the U.S. economy has turned a corner, when it hasn't. While recent economic reports show improvement in the U.S. economy, growth is still happening from a low base. So far, we have seen only one month of satisfactory job growth and retail sales, which is not enough to draw any definitive conclusions about the economic outlook. Currency traders on the other hand have found very little cause for optimism. While Europe has stabilized and the volatility in the FX market has subsided, the two greatest risks for the global economy (the U.S. fiscal cliff and Europe's sovereign debt crisis) still pose an ongoing threat. As a result, we believe that currency traders have the right attitude because caution is warranted.

The divergence between the performance of the currency and equity markets tell us that one asset class needs to correct and we believe it is equities. This may not happen over the next two weeks because the markets tend to be dead during this time period. However, once traders return after Labor Day, which marks the unofficial end to summer, investors will be looking to see if the Europeans will deliver on their promise to protect the euro and if the Fed will provide any additional support to the U.S. economy. If they do not, equity traders could send stocks lower in disappointment, which would compound the losses in currencies.

The most important release on the U.S. economic calendar next week will be the FOMC minutes. When the Federal Reserve met earlier this month, they left monetary policy unchanged and did not provide any fresh clues on their plans for asset purchases. The minutes will most likely be as unsatisfying as the last FOMC meeting.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.