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ANALYSIS-Dollar relationship with risk assets on the rocks

Published 12/07/2009, 05:39 PM
Updated 12/07/2009, 05:42 PM

By Wanfeng Zhou

NEW YORK, Dec 7 (Reuters) - Investors' tendencies since the eruption of the global financial crisis have been somewhat predictable: rush to risky assets when emboldened, retreat to the U.S. dollar when scared.

The push-pull between the dollar and assets such as stocks and commodities has diminished of late amid signs of economic recovery, but it has not broken down entirely.

The beleaguered dollar posted its best rally in a year on Friday, yet stocks edged higher after data showed U.S. employers cut far fewer jobs than expected last month, stoking optimism a sustainable recovery was building.

That was contrary to the pattern seen over the past few months, when good data has tended to pressure the greenback, with investors selling the low-yielding U.S. currency to purchase assets with greater returns.

Friday's strong jobs data spurred speculation the dollar and risky trades may begin to decouple, although most analysts say the inverse link is likely to remain in place for the foreseeable future.

"Investors are on the lookout for shifts in correlations which may signal the end of the U.S. as a pure safe-haven play and becomes a value proposition instead," said Geoffrey Yu, currency strategist at UBS in London. "A full shift may still be months away."

The relationship between the dollar and both stocks and commodities has weakened in recent weeks.

Using daily prices, the 25-day correlation coefficient between the S&P 500 index and euro/dollar was about 0.60 on Monday, the lowest since September 2009. Reuters data showed. In October, the correlation coefficient was as high as 0.93.

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(For a graphic on the dollar's relationship with other assets, click here: http://link.reuters.com/jej55g.)

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BREAKDOWN?

For the correlation to break down entirely, investors will need to become more confident that the U.S. economy is entering a period of sustainable expansion and inflationary pressure is beginning to build up, analysts say.

This would lead to higher interest rates, which would undermine the dollar's role as a borrowing currency of choice.

The dollar became a funding currency on the expectation of low interest rates for a prolonged period of time, which has led to its inverse correlation with the stock market.

"We think that correlation has ended," said Greg Salvaggio, senior vice president of capital markets at Tempus Consulting in Washington.

He believes the November jobs report shows the U.S labor market is improving and suggests the Fed could hike rates sometime toward the end of the first quarter of 2010.

However, Federal Reserve Chairman Ben Bernanke reiterated on Monday that interest rates will remain low for an extended period as the recovery remains fragile.

Markets have been here before. Over the past five months, the dollar has benefited from stronger figures on several occasions, only to return quickly to its more familiar pattern of falling on good economic news.

John Kosar, president of Asbury Research in Chicago, said he does not anticipate a fundamental shift in the relationship until the dollar index sees a sustained bounce above its 50-day moving average.

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The dollar index closed above this average on Friday for the first time since April. Support at this level would suggest reevaluation of the dollar.

"The dollar index would have to rise above its 50-day moving average to indicate that a near-term bottom is in place. Unless that happens, the advance in U.S. equity prices is likely to continue," Kosar said.

Some analysts expect the inverse relationship between the dollar and stocks to follow that of oil, which in recent weeks has not exhibited the linkage seen earlier in the year.

Oil prices have been less influenced by moves in foreign exchange and equity markets over the past month than at any time since March. Oil has fallen since reaching a high near $82 a barrel in late October, even though stocks have risen and the dollar weakened. For more, see [ID:nN07171539].

Of late, gold had been showing signs of decoupling from the dollar. However, the negative correlation between the dollar and gold has strengthened once again after Friday's job report.

As most analysts believe interest rates will remain low through 2010, an ultimate breakdown in the dollar's relationship with stocks and commodities is far off.

"I don't think we're going to get to that point until we start to see more clear signals from the Fed that they're prepared to raise interest rates," said George Davis, chief technical strategist at RBC Capital Markets in Toronto. (Additional reporting by Ellis Mnyandu, Frank Tang, David Sheppard and Joshua Schneyer; Editing by Dan Grebler)

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