The counter-trend movement on the dollar this week will have had currency traders asking themselves whether they should be ready to change their view on the direction of the greenback. I know as I am one of them. The past few weeks and even months have been fairly well set. Any strength you see in Euro/Dollar and Cable you sell, any weakness in Dollar/Yen you buy. Pretty standard stuff really. And why not? The US economy is the leading light of the major economies in terms of recovery, whilst the Eurozone and Bank of Japan continue to lurch ever looser in monetary policy, whilst UK economic indicators have tended to dip back from their strength seen during the summer months.
I am not ready to change my stance on the strength of the dollar in the long run, in fact I believe it more strongly than I did just even a few weeks ago (the recent Non-farm Payrolls report was fairly compelling even if it is likely to be revised lower). However the dip in the dollar in the past few days has been unforeseen and is a hit to the P&L. However I believe that this is only going to be a near term phenomena.
I have noticed that in the past couple of months a negative correlation has built up between volatility on the US equities (as measured by the VIX) and that of the Dollar Index. Trends and correlations will shift and change over time, but right now there seems to be an interesting negative correlation underway. One explanation could be that a spike in the “fear gauge” of the equities market will drive investors to safe haven assets, such as Treasuries, which has a negative impact on the US dollar.
As can be seen in the chart above, since the second half of September there has been a fairly decent negative correlation between the VIX and the US 10 year Treasury yield. Subsequently, since October there has been a pretty good correlation between the US 10 Year Treasury and the Dollar Index too (apart from a few days in late November).
Could this suggest that whilst the VIX continues to rise and investors are “fearful” enough to favour the safety of Treasuries (ie. yields falling), that the Dollar Index will remain under pressure?
The trend questioning moves in Euro/Dollar, Dollar/Yen and to a lesser extent on Cable might therefore continue whilst the market is in this mode of heightened volatility. Also, once the volatility subsides (just as it did in mid October), then we can breathe a sigh of relief and continue to trade the strong dollar trend once more. For now though the choppy dollar trades look set to continue.