Watching those dollar correlations

[Renegade]

Fri Oct 9, 2009 4:46pm EDT


By Jeremy Gaunt, European Investment Correspondent

LONDON (Reuters) - The dollar's decline -- enough so far to trigger intervention from some Asian central banks -- should dominate investors' attention in the coming week if only because of the way it is so closely matched with other assets.

There was a near-perfect negative correlation between the dollar index .DXY, which tracks the greenback against a basket of major currencies, and world stocks as measured by MSCI in September and early October.

In other words, when the dollar was weak, global stocks nearly always rose, or vice versa.

While this link has eased a bit in the last week, it is still very strong -- meaning that dollar-boosting comments such as those on Thursday from Federal Reserve chief Ben Bernanke still have a particularly strong spillover potential.

Bernanke reminded investors that the Fed had the tools at hand to pull back the flood of money it has released into the market -- the so-called exit strategy -- although it was not likely to act immediately.

Dollar weakness has also been behind the sharp rise in gold prices, which are now at record non-inflation adjusted highs well above $1,000 an ounce.

Gold is nearly always in negative lock step with the dollar, but other commodities can also get to the stage where they are driven more by the currency than specific fundamentals.

Another set of correlations shows this to be the case at the moment. MSCI's emerging market stock benchmark .MSCIEF has a strong positive correlation with the S&P GSCI commodities index and an equally strong negative one with the dollar index.

So a weak dollar means stronger emerging market stocks and higher commodity prices.

The key for investors, therefore, will be knowing when the dollar slide is likely to stop and whether these correlations will break down when it does.

EXIT

The Fed, meanwhile, releases minutes of its latest policymaking meeting next Wednesday, while the Bank of Japan meets on Tuesday and Wednesday to discuss interest rates.

Neither is expected to move from their current ultra-easy stance, but the focus will be on what any of the policy teams say about ending the current programmes that are designed to pump liquidity into markets.

The timing of this exit has become a fixation for investors both because of the implications for easy money and because many believe the current equity market rally is dependent on such programmes.

Some are even arguing that the greatest risk to the rally -- which has taken world stocks around 69 percent higher since March with emerging market stocks rising 100 percent -- is unexpectedly strong economic data.

"What you would want is a slow, steady recovery. Too explosive a recovery in activity would bring forward the exit strategies," said David Shairp, global strategist at JPMorgan Asset Management.

"One and a half to two percent (U.S. economic) growth would be just fine for equities, thank you," he said.

Reuters latest polls on the U.S. economy show a median forecast for annualised growth next year of 2.3 percent compared with this year's projected 2.6 percent contraction.

One reason for the caution about a surprise take off in growth is history. A research note from Barclays Capital suggested this week that U.S. stocks do best when economic growth and inflation are both below trend.

EARNINGS ABOUND

The global stock market rally is not only about global liquidity, however. If it is to be sustained, it will also have to be on the back of improved corporate performance.

Investors have already begun being more selective in their stock picking and are no longer happy to reward companies just because their stocks are cheap.

U.S. aluminum giant Alcoa got the U.S. third-quarter earnings season off to a good start this week but investors will need a steady dripfeed of results showing firms' growth and revenues are improving.

Citi is relatively bullish.

"The next phase of earnings recovery is imminent and we expect 50-60 percent to be added to global earnings over the next two years; we are very much in the V-shape recovery camp as far as earnings are concerned," it said in a note.

http://www.reuters.com/article/hotSt...091009?sp=true