The Olympic Games truce, ongoing talks of a more active ECB (yield caps), higher risk appetite, and the Fed's Minutes drove the EUR/USD upward. Yet, the correlation of the pair with other risky assets remained shaky. As can be seen below, the correlation (10-days rolling) between the EUR/USD and the S&P 500, VIX and Brent reversed sharply over the last few days.
It is the fourth time this year. However, such changes of correlation sign are generally very short-lived. They reveal the idiosyncratic risks that affect the European Unit. They also provide interesting market timing signals, as the correlation is generally quick to revert to normal.
For investors, it means either breaking out of the current 1.2590 resistance along with higher stock prices, or clearly, a downward move combined with renewed risk aversion (see, for instance, the unusual positive correlation between VIX -- that is risk appetite -- and the EUR/USD). Here are two likely scenarios for the short run:
As the EUR/USD pushes towards the 1.2582/94 resistance, it may be time to reconsider a "back to normal" strategy. In other words, making sure that cross asset "traditional" correlation comes back into play.
- An increase in risk aversion that could propel stocks further downward: the current global economic slowdown was confirmed today in Europe and China, with very bad readings for the exports/orders components. As a result, prospects for EPS could be revised further downward (see chart below). This is bad for stocks, and it would definitely drive the EUR/USD down, too (USD is a safe haven, as usual).
(click images to enlarge)
Oil prices should follow suit. Global demand for oil in OPEC's August report was almost unchanged. Although OPEC reduced its daily production, according to the latest OPEC report, it is still supplying more oil than required. It suggests that there is a real potential for Brent to head back to 105/07 quickly.
2. The odds for a stronger EUR/USD (1.27) in the short run do exist, though. They would be confirmed by a bolder than expected QE3, which would have a negative impact on the USD. The Fed's Minutes are not enough to guarantee such a scenario unless Bernanke confirms it next week at Jackson Hole (see our Instablog for more on this).
Even though we favor the first scenario, we expect a rapid recoupling of the EUR/USD with other risky assets. The signal sent by temporary correlation breaks like we have now is this: you do not need to get the direction right, you just have to bet on a VERY LIKELY reversion of correlation to "normal" (fourth time this year!).
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
