The Great Divergence
Over the past week, both investors and traders been amazed by the growing dichotomy between the performance of theUS equity markets and the US dollar. While the Dow Jones Industrial average has continued to rally relentlessly closing within just a few points if its all time high at 12,786, the dollar has plunged in the currency markets, with the pound now trading at 26 year highs above the 2.000 level while the EURUSD is within striking distance of taking out its all time high of 1.3666 set in 2004.
Overall, the dollar index has broken critical support at 82.00 and may be well on its way to plumb a ten year low of 80.53.
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 the US 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 pounds 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 regions 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.
