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S&P Downgrade – What it Means: Stocks Collapse, Dollar Jumps

By , Quantitative Strategist
08 August 2011 16:51 GMT

A Standard and Poor’s downgrade of the US Sovereign Credit rating sent stocks reeling – here’s what it means for major currencies.

The US Dollar traded higher against all major currencies except for the safe-haven Japanese Yen and Swiss Franc in response to the Standard and Poor’s credit rating agency downgrade of US sovereign credit. The unprecedented event left traders scrambling for safe-haven assets, and the US Dow Jones Industrial Average fell over 2 percent in the moments immediately following the stock market open.

US S&P 500 Falls Nearly 4% on S&P Downgrade of US Debt

us_dollar_s_and_p_downgrade_us_body_Picture_4.png, S&P Downgrade – What it Means: Stocks Collapse, Dollar Jumps

Source: Bloomberg

The effects on currency markets were swift and straightforward. Safe-haven currencies benefited substantially, while riskier counterparts fell sharply on the sudden equity market sell-off.

us_dollar_s_and_p_downgrade_us_body_Picture_5.png, S&P Downgrade – What it Means: Stocks Collapse, Dollar Jumps

Source: Bloomberg

All G10 currencies except the Japanese Yen and Swiss Franc traded lower against the US Dollar following Standard and Poor’s announcement. The Swiss Franc has been the top forex investor’s choice during times of heightened market tensions, while the Japanese Yen has remained similarly correlated to the S&P 500. Yet one of the top trading opportunities going forward may actually come from the opposite end of the ‘risk’ spectrum—the Australian Dollar.

us_dollar_s_and_p_downgrade_us_body_Picture_6.png, S&P Downgrade – What it Means: Stocks Collapse, Dollar Jumps

A historical look at the Australian Dollar/US Dollar pair emphasizes that it has remained highly correlated to the S&P 500 and broader financial market risk sentiment. Yet the strong correlation suggests that the Aussie Dollar should have fallen even further against the US Dollar than it has, as the S&P 500 has fallen sharply.

The noteworthy disconnect suggests that the US Dollar has underperformed what may be a significant turnaround in financial markets. If we see the multi-year correlation hold true, there is significant risk that the AUDUSD may fall further on a continued down-move in stocks.

Those same correlations suggest that the AUDCHF and AUDJPY pairs could fall sharply on the same market turmoil following the S&P downgrade. Yet there are two key factors that limit the attractiveness of Japanese Yen and Swiss Franc long positions—the Bank of Japan and the Swiss National Bank.

Whereas the BoJ and SNB could theoretically move to stem any further CHF and JPY advances, there is arguably little in the way of further US Dollar strength on financial market turmoil. This obviously assumes that the US Dollar remains a safe-haven despite the S&P downgrade. Yet price action in US Treasury markets suggests investors are not fearful on the perceived loss of creditworthiness.

Traders have ironically poured into the very instruments that were downgraded—US Treasury Bonds. The 2-year US Treasury yield fell to its lowest level on record, while the 10-year Note yield broke key technical support and is at risk of declines to fresh record lows.

US 10-Year Treasury Note Yield Breaks Multi-Year Uptrend as Markets Flee to Safe Havens

us_dollar_s_and_p_downgrade_us_body_Picture_7.png, S&P Downgrade – What it Means: Stocks Collapse, Dollar Jumps

Source: Bloomberg

Despite the Standard and Poor’s downgrade of the US sovereign credit rating, investors continue to buy US Treasuries and should theoretically favor the US Dollar against higher-yielding forex counterparts.

G10 Currencies Ranked by 3-Month Deposit Rates

us_dollar_s_and_p_downgrade_us_body_Picture_8.png, S&P Downgrade – What it Means: Stocks Collapse, Dollar Jumps

Source: Bloomberg

If forex correlations against the S&P 500 hold, we could expect the US Dollar to rally further against the Australian Dollar, New Zealand Dollar, Euro, and Canadian Dollar on broader financial market turmoil. Early reactions suggest that the S&P downgrade of US Treasury debt may actually result in short-term Greenback strength. The fact that the Greenback has underperformed historical correlations in the immediate aftermath suggests it may have further room to run.

Written by David Rodriguez, Quantitative Strategist for DailyFX.com

To contact the author of this report, e-mail drodriguez@dailyfx.com

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.
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08 August 2011 16:51 GMT