Friday, August 21, 2009

RALLY OVER? THURSDAYS' FX/COMMODITIES' DIVERGENCE FROM STOCKS—A 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 (Experience 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:



Sell: 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)

Sell 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),

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

Sell the following commodity ETFs: (USO) (OIH) (GLD) (SLV)

Disclaimer/Disclosure: The above opinions are not necessarily those of AVAFX. The author may hold positions in the above instruments.

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