The currently volatile market environment is making it especially challenging for traders and investors to manage their portfolios. There is, however, one very clear trend that, if we follow it closely, can lead to great profits and much more clarity.
The trend I am talking about is the inverse correlation of risk assets to the U.S. dollar.
Correlation measures how two assets trade in comparison to each other. And in broad terms, inverse correlation means that as one asset appreciates, the other depreciates … and vice versa.
Before we take a closer look at the dollar correlation, let’s note the heightened volatility in the Chicago Board Options Exchange’s Volatility Index (CBOE:VIX), where 20 is the new 10.
In other words, 10 used to be the low end of the volatility range. But in today’s headline-driven schizo-market, 20 might be the low end of the range in the VIX for some time.
The inverse correlation of the dollar to risk assets has been apparent for some time, and it continues to be the case. Since mid-October, the broader equity market — as measured by the S&P 500 (SPX) — has gyrated between 1,150 and 1,290. By so doing, this put many (if not most) portfolios through the meat grinder.
Most players might fare best by sitting out during this wide and volatile trading range, at least until a trend in either direction ensues. However, the dollar always gives us early clues as to whether risk is on or off.
Generally, from a cross-asset class perspective, the U.S. dollar remains the key variable for the risk trade. More precisely, if the dollar can catch a sustainable bid, then risk assets such as equities will come under further pressure.
The correlation chart of the S&P 500 versus the U.S. Dollar Index (DXY) clearly shows the inverse relationship. During the past 12 months, this inverse correlation has been about -0.58.
Let’s take this a step further and look at the correlation of the Dollar Index versus the S&P 500, 10-year U.S. Treasury notes, and the CRB Total Return Index (a basket of commodities).
Note the correlations in the table below, and you will find that all these risk assets are inversely correlated to the dollar and, hence, positively correlated to each other.
The chart of the Dollar Index shows a formation of higher lows and higher highs with resistance near the 80 mark.
From a purely cyclical standpoint, a break of 80 would be bullish for the dollar and, therefore, bearish for risk assets.
The assumption, of course, is that this inverse relationship between the dollar and risk assets will remain. Correlation assumptions are a dangerous thing, and many banks and investors have gotten burned from assuming that correlation would be a constant.
Because correlation isn’t constant and can change at any time, how is the correlation between the dollar and risk assets likely to change over the next few weeks?
Given the current global economic headwinds at work, the correlation should remain roughly equally inverse — as it has been over the past 12 months.
If and when the dollar should begin to meaningfully plow higher, however, we expect risk assets to sell off proportionally more. So, an increase in correlation would be expected.