ICAP On The Correlation Collapse
Submitted by Nic Lenoir of ICAP
We have been making a case for long USD positions against JPY, AUD, and EUR recently. A quick look at the DXY chart shows that a close through the 50-dma would trigger a collapse of a massive carry trade. We are no there yet, but there are reasons to believe it is a strong possibility.
First looking at the Gold chart, the weekly candle is dreadfully bearish, we have had weekly divergence on every new top since 2006, and we failed close to the multi-year channel resistance which is currently at 1256. So technically, while the reversal pattern is not complete yet, since the bearish hammer needs confirmation next week to form an evening star, we have quite a handful of bearish elements.
Then we looked at the 90-day correlation between gold and stocks. We find interestingly that the market goes through approximately 1 year cycles of sharp positive or negative correlation, the interesting constant being the duration of the cycles. They correspond to various states of market regimes. The past 9 months have been marked by a strong correlation of all risky assets. After a strong period of risk aversion, low rates and government backstops have pretty much encouraged money managers to buy anything other money markets in low yielding currencies. Interestingly it looks like we are at the peak of this correlation cycle, and the post NFP price action this morning with equities AND the USD rallying while commodities are being sold aggressively is a good confirmation of what our correlation cycle peak indicates. Note that this is a 90-day correlation, so the correlation chart will reflect the turn with a lag. Being at the top basically mean we have already turned.
A turn in correlation can mean two things: the first case is that we enter a period of consolidation as part of the simultaneous bull market in commodities and equities where the correlation will go down to zero before picking up in a year as the next leg of the bull market starts. This would leave us with a year of choppy price action where the various asset classes decorrelate and little progress is made. The second case is a return of risk aversion. In that case the correlation would get into a negative 1Y cycle which has historically been synonymous with asset destruction. One thing is for sure, the short-USD buy anything else regime is now over, and certainly this will have interesting consequences on relative value strategies. An easy conflicted sector comes to mind and it is commodity stocks. If commodities and equities decorrelate, then surely there will be a downside story no matter what to stocks in the commodity space, which means the best one can hope would be to break even. Selling calls can be a good way to express the view.
Bear in mind, as the chart of the correlation between Gold and CPI shows, there is no comparison possible with the last gold spike of the last 70s in terms of underlying framework. Gold has been a reactionary trade against fiat currencies and a hedge for asian central banks against their USD holdings. The trade is basically a carry trade, and has been fueled with a lot emotion with targets of 5,000 being mentioned for the most enthussiastic analysts. However, it is all conditional on a sharp pick up in inflatoin that has yet to manifest itself, and with 10% unemployment and quite a bit of capacity slack it is doubtful that this scenario is imminent.
Since I started typing the S&P futures have reversed their advance, not surprisingly so as overall when market structure breaks down it tends to affect equities negatively. We will watch carefully 50 day moving averages in FX, and the 100-dma in Dax. We have also been pointing out the strong divergence on daily scale of the S&P and DAX the past week, so we have a pretty strong case for a reversal building. Brace yourselves, this move could have some legs.
Good luck trading,