Monday, November 2, 2009

Stocks vs Currencies: Which Moves Which? Must Know Basics

In the Short Term, Equities Generally Drive the USD and Other Currencies , Not Vice Versa

Here's an important point to clarify. Over the past week, there seems to be a common notion in the media (check out Yahoo Finance's weekly recap- I believe from that a rising USD was driving stocks lower. We disagree strongly, and suggest that such analysts were simply casting about for an explanation other than the one supported by far more evidence-that the current rally is overbought and due for at least a correction if not reversal.

In fact, most of the time the opposite is true- in the short term stocks drive the USD (and currency trade in general). While currency trends can and do affect equity markets, that influence tends to be more gradual, whereas stock market movements tend to have immediate impact on currency markets. Much of the reason for this is that 80% of currency trading is speculative, mostly very short term. Equities tend to be held for longer periods.

When Stock Markets Are Optimistic, Currency Traders Sell Dollars

Why? Global stocks, arguably best represented by the S&P 500, are widely believed to be the best barometer of optimism about growth prospects, aka risk appetite, or pessimism, aka risk aversion.

When there is risk appetite, traders buy currencies that tend to rise when there is growth (for a variety of reasons, but mostly because these offer the highest short term yields). These are referred to as risk currencies, the main ones being the AUD, NZD, EUR, and CAD).

When Stocks Markets Retreat, Currency Traders Buy Dollars (also JPY and CHF)

When there is fear or risk aversion, the risk currencies are sold and traders buy currencies that tend to rise in times of fear. This group is known as the safe-haven currencies. The USD has, over the past few years, generally been the #2 most in-demand safe haven currency, after the #1 JPY, though in some ways it's becoming the #1 safe haven currency.

These Labels Refer to Market Behavior Only, Not Fundamental Store of Value Safety

Understand that these labels do NOT at all mean that one currency is actually a better or less reliable store of value than another, indeed some of the "risk" currencies have much better fundamentals than the safe havens, and are backed by far healthier banking systems that are largely unburdened with bad debt, unlike the USD.

Rather this nomenclature simply refers to how the currencies behave in times of optimism of pessimism.

Because risk and safety assets tend to move in opposite directions at the same, which asset influences which is not always clear to casual observers. To further complicate matters the roles do at times briefly shift, and the primary forces that drive a given currency price can and do change over time.

Appreciating Currencies Affect Their Economies Over a Longer Period Than Stocks Affect Currencies

Short term currency moves thus generally have little short term influence on stocks, whereas short term stock market movements have immediate influence on currency pair prices.

In the long run, a rising currency clearly can hinder economic growth by making a country's exports more expensive, and thus can weigh on stock prices WHEN it becomes clear that the appreciating currency is hindering export growth. That, however, takes time, though on a given day analysts seeking an excuse for stock movements will blame currencies. Often that is misguided.

This is true for all economies to varying degrees, though in fact far less so for the USD, since most of US GDP is from consumer spending, NOT exports. As a net importer, when the US economy is healthy and importing, the US economy reaps benefits, especially in the short term, from a strong USD because the imports become cheaper.

However, most currency trade is from very short term speculative traders, and in the short run, they look to the direction of stocks to decide whether to go long or short on the risk currencies or safety currencies.

Why is the USD a Safe Haven Currency (at least for now)?

Since the current downturn began, the USD started trading as a safe-haven currency, i.e. one that traders buy ONLY in times of rising fear. Without getting too much into the technicalities of why this is the case (like that it's used as a funding currency of carry trades) suffice to say that it behaves this way due to the USD's poor fundamentals, including:

• Low income: yield low short term yields that are likely to be among the last among the major currencies to rise, thus one gets very low returns from holding low risk USD debt

• Low chance of capital gains due to (at least perceived) ballooning supply that is widely believed to virtually guarantee inflation/devaluation), thus making the USD a poor holding for capital appreciation

Currencies always trade in pairs, for example, the EUR/USD. When you buy this pair, you are buying EUR and selling USD. The EUR is valued in USD. Because its yields are low, currency traders tend to borrow (sell) it in order to buy currencies more likely to rise.When stocks retreat, those trades unwind and traders need to buy back the USD when the 'sell ' the EURUSD.
Thus the only reason to hold the USD is that these days it DOES usually behave as a safe haven currency, meaning that it rises when there is risk aversion and falls when there is risk appetite. Because stocks are currently seen by currency traders as the prime barometer of risk appetite, the safe-haven USD falls when stocks rise and vice versa when they come in.

Disclosure: The author has no positions in the above instruments

1 comment:

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