So why has the divergence between
the equity and the currency markets become so amplified over the past few weeks?
The answer may lie in the difference of focus between stock and FX traders. The stock market
rally appears to be fueled by the relief that theUS
economy continues to perform relatively well, with little risk of recession in
the foreseeable future. The
currency traders on the other hand are almost solely interested in yield and
that single minded preoccupation has hurt the greenback as US monetary policy is
likely to remain neutral throughout 2007.
Equities – No Recession in
Sight
After suffering a sharp correction
in the wake of a the sub-prime blow up, the equity market found its footing and
quickly recovered to new highs, as worries of an imminent US
recession dissipated. The primary driver behind the rally was the latest
US employment report which surprised
to the upside as it printed at 180K vs.
97K expected while the unemployment rate dropped to a near 5 year low of
4.4%. The employment data suggested
to equity traders that jobs remained plentiful and economic growth was likely to
continue albeit at perhaps a slower pace. In addition the latest US
inflation data released just yesterday showed a marked slowing in price
pressures, as core component rose by only 0.1%. The news further buoyed equities
as traders now believed that monetary policy would remain neutral while growth
would continue creating a perfect environment for further appreciation. Coupled
with good numbers from Citibank, Intel and Washington Mutual and set against the
backdrop of multi-billion dollar buy-out deals, the meteoric rise in stocks over
the past few weeks can be understood.
Currencies – Where is My
Yield?
Yet,
some of the factors that are proving to be favorable to the stock market are
becoming a serious handicap for the US dollar. With the currency market strictly
focused on yield and more specifically on the potential for expanding yield,
there is little surprise that the greenback has suffered. Even if US
growth continues to be positive its relative growth versus the major trading
partners has slowed significantly. As can be seen in the chart below, US GDP has
lagged the GDP growth rates of EU,
UK and even Japan
since the middle of last year.
The net impact of that dynamic is
that the Federal Reserve has kept rates on hold for more than ten months while
the ECB, the BoE and even the BOJ have all hiked the repo rates in the meantime.
More importantly, the currency market expects to see further rate hikes from
both the BoE and the ECB in the near term.
The pound’s recent rally has been fueled by speculation that the
UK central bank will have to
raise rates not once but twice given the strength of recent UK data
which showed marked rises in producer, consumer and wage price levels. While the
expectations for the ECB are more muted, most currency traders also expect two
rate hikes from Mr. Trichet and company given the region’s strong economic
performance despite the high value of its currency.
Which Market is
Correct?
Yet in addition to the different
concerns of the two markets, the massive divergence in the price of stocks
relative to the price of the dollar also reflects a diametrically opposite view
of the future of the US economy. The stock market is unabashedly
optimistic believing that US housing woes will remain contained as US corporate
profits, and an easy monetary policy will sustain the rally via growth and
additional acquisitions. The currency market is far more guarded in its view
about the outlook of the US economy. FX traders see a marked
slowdown of activity in the Industrial sector, relatively tepid increases in
retail spending and no catalyst to reignite US
growth in the 2nd half of the year.
Overall, even if the US economy manages to muddle through, global
capital sees better values elsewhere as growth in other parts of the world
continues to exceed US performance. The answer to the
question of which market is correct will likely lie with the upcoming US jobs
and income data. With the US
consumer saddled with enormous amount of debt whose service value grows every
month, and with housing no longer serving as a key source of income via mortgage
equity extraction, only an increase in jobs or wages would allow US
consumer demand to continue expanding at healthy pace.
In the meantime, we leave you
with one final chart which shows the value of Dow Jones in terms of the US
Dollar index. Expressed this way, the stock index rise looks even more
parabolic. For those investors old enough to remember the 1987 stock market
crash, which according to many
analysts was triggered by the weakness in the dollar, this picture may serve as
a sign of caution to equity bulls everywhere.
