Dollar vs. Dow: Plenty of Reasons for Volatility to Continue Next Week

If you watched the stock market today, it is not hard to imagine what went on the currency market. For the past few months, we have either seen carry trades follow the ebb and tides of US stocks or the reverse (see our latest report on this relationship: EUR/JPY and the Dow - Separated at Birth?).

The correlation stems from the fact that the yen has become the primary funding vehicle for investors looking to get into US stocks, making the carry trade the poster child of the risk seeking world. The 157 point rally in the Dow today has erased 79 percent of yesterday?s losses bringing carry traders back with a vengeance. The outlook for higher interest rates in countries like New Zealand has sent the NZD/USD to a fresh 25 year high. This very dynamic is what will limit the losses in carry trades even if this is the last hurrah in US stocks. The latest wave of dollar strength, which was limited to the Euro, British pound and Japanese Yen, was triggered by the intraday reversal in yields, the drop in oil prices and the stronger US trade balance. Ten year bond yields hit a high of 5.24 percent, but ended the day in negative territory. Oil prices slipped as the cyclone in the Middle East loses strength. We are also finally seeing the benefits of the weak US dollar. The trade deficit dropped significantly in the month of April as import demand subsided while export demand hit a record high. The increase in exports is the main reason why many economists including Federal Reserve Chairman Ben Bernanke are looking for stronger growth in the second half. In the week ahead, the US economic calendar is light, but US retail sales, producer prices and the Fed Beige Book report are always important. Don?t expect volatility to let up with consumer spending and inflation reports also due for release from countries like the UK and New Zealand next week.