Last week, I wrote about the incredible connection that had formed between currency markets and risk assets including stocks, bonds, commodities, oil and precious metals. Just a quick glance at the charts shows just how closely the ups and downs of the dollar exchange rate is controlling trading.
In fact, according to Jason Goepfert of SentimenTrader, the relationship between the dollar and stocks has reached an all-time record.
The statistical correlation between the U.S. dollar and the S&P 500 over the past month is at -0.86 and has been below 0.80 for 28 consecutive days — a new all-time record the rolling one-month correlation between the two. Previous streaks have reached 20 straight days a handful of times. Correlation measures range from +1 to -1, with -1 indicating a perfect inverse relationship between two assets.
This is a very unusual situation. Theoretically, stocks and currencies shouldn’t have much of a connection at all since they are pushed and pulled based on a completely different set of factors. Indeed, the long-term correlation between the two is zero — meaning they have no relationship at all.
Goepfert notes that it’s quite rare to see the correlation move beyond +0.60 or -0.60 for more than a few days at a time. So the behavior of the past few months has been very out of the ordinary. We’re in uncharted territory here.
So what should investors do? With asset correlations rising, and with extremely volatile foreign exchange markets apparently calling all the shots, I think the focus for most investors should be on protection against a dramatic and disorderly decline as these dollar-drop sensitive trades are unwound.
To that end, cautious investors would be wise to consider adding some long dollar exposure to their portfolios via the PowerShares DB US Dollar Index Bullish Fund (NYSE: UUP), which given current correlations would be expected to rise during a stock market correction. Another option would be to add short exposure on foreign currencies like the Japanese yen or the euro. There are two leveraged inverse ETFs that fit the bill: the ProShares UltraShort Euro (NYSE: EUO) and the PowerShares UltraShort Yen (NYSE: YCS).
Disclosure: The author does not own or control a position in any company mentioned.
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