Most traders are familiar with the market correlations created by the low interest-rate policies and outright bond buying of central bankers. Currencies and commodities have been following the stock market higher since early 2009 when the U.S. launched what became known as QE I, a massive financial push toward driving interest rates lower to stimulate the economy and reverse job losses. The chart in Figure 1 highlights these market correlations. The U.S. stock market as represented by the S&P 500 is in green, the Australian dollar is in blue, while crude oil is in black. The S&P 500 and the Australian dollar have vied for leadership throughout this period because of real investment demand. They are asset class markets - they both have a yield or a dividend and enjoy solid financial ratings - so they are accumulated by institutions who are deploying the capital entrusted to them from their clients every pay day. Crude oil is always in demand also, but is not considered an asset class market because you do not get paid a "carry" to hold it, you actually incur the carry because you have to pay to store it, as in all commodities. This is why commodities and low yielding currencies are considered more speculative than asset class markets.
What is also significant about these correlations to traders today is which market is leading and which is lagging, and what does this tell us about how we position ourselves as traders? As a rule, the markets are most healthy when led by asset class markets because of real investment demand, and less healthy when being led by commodity markets or no-to-low interest currencies such as the euro.
When we take a further look at these correlations on a shorter term Daily chart in Figure 2, and include the euro in yellow, we see a market that had been lagging and is now moving into a leadership role. From a short-term, or day-traders perspective, this is important. If you have a choice between taking a buy signal in the AUDUSD, or EURUSD, and you see the euro is clearly stronger, we advise "buy strength," and take the signal in the euro. Buy strength and sell weakness is textbook advice which we teach in our Core Concepts course. From a longer-term perspective however, we realize that a market where the low-to-no yielding instruments are leading is not a healthy environment longer-term. In fact, we can see the order which these markets topped out in the late winter, early spring, when the euro usurped the leadership role from the higher yielding Aussie. We circled in red where each market broke its uptrend before putting in a lower high. The asset class markets gave sell signals before the low yielding euro and negative carry commodity. It is imperative for us as traders and investors that we know if the market is being led by asset class markets or not.
While the euro has the ability to take that alpha spot for financial markets from time to time, it is not a sustainable position because of its small yield and thus lower investment demand.
When the euro does manage to gain that alpha position, we see it as a sign of caution. Figure 3 highlights a four-hour chart going into Monday's U.S. session close with the euro currently leading the uptrend. While we don't specifically use the correlations as triggers, they do play a part in which trade set-ups we choose and help to remind us of the health of the current trading environment.
In this business the simplest explanation is usually the best. So why could euro strength portend overall market weakness? For the same reason that the market with the most shorts in it gives the biggest short covering rallies - market health is equated to market strength and sustained strength comes from investors and savers accumulating a market timed to the global pay day cycle. The euro has not taken the lead because of sustainable strength but because of hedge fund short covering. And we will likely see more of that as hedge fund investors decide to exit funds whose managers opted for short euro positions earlier in the year. Quarter-end hedge fund redemptions are a real threat to even the healthier asset class markets. If leading indicator indices such as the S&P 500, and alpha markets such as the Australian dollar, are to see price corrections lower between now and year end, it is our belief it will happen sooner rather than later.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.