Wednesday, February 1, 2017

Watching the USD for clues to equity market direction

Mid-week market update: With stock prices pulling back to test its technical breakout to record highs, it is perhaps appropriate to watch other asset classes for clues to equity market direction, especially on a day when the FOMC made its monetary policy announcement.

From a cross-asset perspective, there is much riding on the direction of the USD. As the chart below shows, the USD Index has weakened after making a high in December. It is now testing a key support zone, as well as a Fibonacci retracement level. Despite the pullback, the uptrend remains intact.

The other panels of the chart shows the UST 2-year yield and its rolling 52-week correlation with the USD. As well, I show the price of gold and its rolling correlation to the USD. The correlation charts show that the relationship between the USD and these two assets have been remarkably stable. The USD has been positively correlated to interest rates, as measured by the 2-year UST yield, and inversely correlated to gold prices.

As well, please be reminded that gold and equity prices have recently shown a negative correlation. In the past few months, stock prices have risen when gold fell, and vice versa.

With these cross-asset, or inter-market, relationships in mind, what happened to the USD in the wake of the Fed announcement?

Nothing. Sure, the greenback weakened a bit in response to the FOMC decision, but soon bounced back. The same could be said of interest rates, and stock prices.

That leaves investors and traders waiting for a decisive break for clues to stock market direction. Equities are mildly oversold, but my metrics of risk appetite remains in an uptrend. I am inclined to give the bull case the benefit of the doubt, but with reservations.

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