It’s not often that currencies are the headline story in the financial markets, but that’s the case right now — or at least it should be.
While most investors are focused on the rally in equities, the real story is playing out on the world’s FX trading screens.
First, some background. July 24 and 25 proved to be game-changing days for the financial markets, as the Federal Reserve and European Central Bank both telegraphed their intent to intervene in the markets if need be. On the 24th, the Fed provided its first quasi-official hint that another round of quantitative easing was on the table via an article by Wall Street Journal reporter Jon Hilsenrath. The next day, ECB chief Mario Drahgi came out and said, “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”
The result, of course, has been a dramatic rally in the global equity markets and other higher-risk asset classes. But beneath the surface is the real driver of the markets’ explosive move — the rally in global currencies.
Since July 24, the CurrencyShares Euro Trust ETF (NYSE:FXE) has surged 6.5%. This isn’t exactly an Apple-like return, but it does mark the largest upward move in this beleaguered ETF in nearly a year.
Click to Enlarge Even more notable is that FXE crossed above its 200-day moving average on Wednesday morning — the first time it has been above its 200-day since late October 2011.
FXE isn’t alone in its rally — CurrencyShares British Pound Sterling Trust (NYSE:FXB), CurrencyShares Swiss Franc Trust (NYSE:FXF) and CurrencyShares Canadian Dollar Trust (NYSE:FXC) also have registered gains of varying sizes.
The flip side of this, naturally, is the weakness in the U.S. dollar. Since July 24, PowerShares DB US Dollar Index Bullish Fund (NYSE:UUP) has been hit for a loss of 5.2%.
Why does this matter to investors? After all, most people don’t trade the currency ETFs. Not only are they esoteric products, but most of the time they’re also fairly slow-moving.
Well, it’s essential to keep an eye on the FX markets because they’re such an important indicator of sentiment. When the dollar goes down so quickly — as it has in the past month-and-a-half — it’s a sign that the world’s most sophisticated investors are moving firmly into the “risk-on” camp.
That’s why investors need to keep a close watch on the behavior of FXE around its 200-day moving average. The last time the ETF broke above this key indicator, it only stayed in bullish territory for two days before diving nearly 10% in the next two months. If this move proves more sustainable, it’s the clearest sign investors will need that the European debt crisis is no longer going to be the all-pervasive issue it has been in the past two years.
In addition, the falling dollar is having a positive impact on companies with a large percentage of overseas sales, such as Texas Instruments (NASDAQ:TXN), Ford (NYSE:F), Exxon Mobil (NYSE:XOM) and International Business Machines (NYSE:IBM). A failure in the euro here would likely cause the rallies to stall in these and other stocks with high foreign revenues.
Gold and silver also have benefited tremendously from the sell-off in the dollar. Since July 24, the SPDR Gold Trust (NYSE:GLD) and iShares Silver Trust (NYSE:SLV) have rallied 9.4% and 23.6%, respectively, and blown past longstanding upper trendlines in the process.
Bonds, too, are affected by this risk-on trade. The yield curve has steepened considerably in the past few weeks (meaning rates longer-term bonds are rising faster than those on shorter-term issues). This is reflected in the performance of the iPath US Treasury Steepener ETN (NYSE:STPP), which has had an almost perfect correlation — 0.92 on a scale 0f -1.00 to 1.00 — with FXE during the past year.
The Bottom Line: No matter where you’re invested, the euro should be on your radar screen right now. Watch FXE closely in the days and weeks ahead, because it just might provide the clue as to where the rest of the financial markets are headed next.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.