If it seems as though just about every tradeable asset class is moving in the same direction right now, it’s not just your imagination.
Since late July — when the U.S. Federal Reserve and European Central bank communicated their plan to do “whatever it takes” to maintain growth and protect the eurozone, respectively — just about every segment of the financial markets has been keying off of the euro.
The table below shows the correlations between some major asset classes with the euro, as gauged by the CurrencyShares Euro Trust ETF (NYSE:FXE) since the July 24 Wall Street Journal piece that telegraphed the Fed’s intention to do another round of quantitative easing if necessary. Keep in mind, correlations run in a range from -1.0 (perfectly uncorrelated) to 1.0 (perfectly correlated). From this data, it’s clear that recent correlations with the euro have been well above historical averages for stocks, bonds and gold.
|CORRELATION, 7/24-8/20||5-YR CORRELATION|
|FXE vs. 10-Year Treasury Yield||0.59||0.54|
|FXE vs. SPDR S&P 500 ETF (SPY)||0.80||0.26|
|FXE vs. SPDR Gold Trust (GLD)||0.59||-0.33|
These asset categories aren’t alone, however — correlations with the euro are also well above historical norms for high-yield and emerging-market bonds, foreign stocks (both developed and emerging) and all sectors of the U.S. market except utilities. Commodities — as measured by PowerShares DB Commodity Index Tracking Fund (NYSE:DBC) — also are tracking the euro higher, although oil accounts for the majority of this.
Among the few investments that have provided any measure of diversification since late July have been corporate bonds, utility stocks and base metals — and none of these are places you would have wanted to be.
This type of market action is indicative of “risk-on” conditions taken to the extreme. As such, it’s important to remember that rallies driven by hopes for a meaningful solution to Europe’s crisis generally have had a limited shelf life. This might be especially true now, given that the rally has occurred amid thin, late-summer trading volumes. As a result, the move is highly vulnerable to the potential for adverse headlines.
As for the euro itself, a look at the past year shows that none of its periodic upturns have evolved into sustainable rallies. Without a more definitive move in FXE above its upper trendline (about $126.40) or its 200-day moving average ($128.63), the current rally in higher-risk assets might be short-lived. Alternatively, a bullish disconnect from this recent trend — a weakening of the euro accompanied by continued gains in the higher-risk asset classes — would be an extremely bullish sign for stocks.
On the other side of the ledger, a drop in FXE below $122.50 would be a strong indication that the rest of the financial markets might be destined for some turbulence.
The bottom line: Correlations ebb and flow, but the lockstep movement of the past few weeks has been unusual, even by the standards of the risk-on/risk-off market of recent years. Until something changes, keep your eyes fixed on the euro as the leading indicator for the rest of the financial markets.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.