Risk-appetite has ticked higher steadily since last Wednesday, up 5.49 percent, when the FX Carry Trade Index was at its lowest level since August 2010. Similarly, the U.S. equity markets have rebounded over said period, with the S&P 500 gaining 6.37 percent.

The relief in equity markets could be short-lived, however. A tenet of technical analysis is that a move by an asset (commodities, currencies, equities, etc) is considered to be ‘technically strong’ if there is strong volume supporting the move. Such has not been the case. Volume has been lacking behind the recent gains in equity markets in recent days, especially compared to recent averages.

A popular counter-argument to this suggestion is that volume, especially in the month of August, is historically low. However, that has not been the case this August, in light of the European sovereign debt crisis as well as the downgrade of the U.S. government’s sovereign debt rating by Standard and Poor’s. August 2011, already, is exhibiting symptoms August 2010 showed: a meltdown in equities following the end of liquidity injections by the Federal Reserve.

Higher_Volume_Begets_Losses_in_Post-Quantitative_Easing_Markets_body_Picture_1.png, Higher Volume Begets Losses in Post-Quantitative Easing Markets

Prepared by Christopher Vecchio

During the second round of quantitative easing, from November 3, 2010 to June 30, 2011, the S&P 500 traded mostly higher, rising from 1221.06 to 1320.64, as noted in the chart above. Volume was both dense and thin, and the correlation between the S&P 500 and volume was an insignificant -0.14 over the life of the Federal Reserve’s liquidity injections vis-à-vis quantitative easing.

Higher_Volume_Begets_Losses_in_Post-Quantitative_Easing_Markets_body_Picture_4.png, Higher Volume Begets Losses in Post-Quantitative Easing Markets

Prepared by Christopher Vecchio

Since July 1, the day after quantitative easing round two ended, a quite different story has unfolded. The S&P 500 has dropped from near 1350 to as far as 1100. Volume, on the other hand, has been steadily increasing, as noted in the chart above. The correlation here, albeit, on a smaller pool of data, is significantly stronger: a -0.88 correlation.

Certainly, this is cause for concern. A brief glance over correlations between currencies, equity market performance and volume necessarily suggests that currency traders maintain cautious optimism towards the riskier assets, especially the long-components of the FX Carry Trade Index.

As David Rodriguez, Quantitative Strategist noted in a report today, “The Australian Dollar’s link to the Dow Jones Industrial Average likewise trades near record-strength, and the AUD/USD remains a speculator’s favorite as a proxy to stocks and commodity prices…Thus if you believe that the DJIA is headed higher, the AUDUSD represents an attractive and more liquid alternative to straight bets on the Dow itself.

I would point out that, like the DJIA, the S&P 500 shares a near-identical correlation with the AUD/USD, while also sharing an equally significant negative correlation (positive with the Loonie) with the USD/CAD. Accordingly, as the data suggests, if volume picks up, the S&P 500 will likely fall, and given their correlations with the S&P 500, the Aussie and the Lonnie, components of the aforementioned FX Carry Trade Index, will likely fall as well against their American counterpart, as well as the other safe haven currencies, as risk-appetite tapers off once more.

Written by Christopher Vecchio, Currency Analyst

To contact the author of this report, please send inquiries to: cvecchio@dailyfx.com

Follow Christopher Vecchio on Twitter: @CVecchioFX