Market Correlations Out of Sync Ahead of FOMC

By now, I’m sure you have all heard that the NFP report came out better than expected, printing job losses of 247,000, bringing the unemployment rate to down to 9.4% from 9.5%. Actually, it seems fishy – a quarter million jobs were lost and yet the unemployment rate went down? Looking at the headline number, it just doesn’t add up. In any case, now that the NFP storm has passed, it’s time to take out the covers, unbolt the windows and take a look at the aftermath.

Since the collapse of the financial system, the USD has traded inversely versus equities. This means that when stocks and other higher yielding assets rise, the dollar’s value falls against other currencies like the EUR and the GBP. This kind of perception on the market has been widely accepted as true but the dollar’s price action after the release of the NFP report last Friday begged to differ! The dollar won out, rallying against the EUR, GBP, CHF and JPY, despite the improvement in the US job market.

Has the inverse correlation between the US capitals markets and USD strength finally been broken? Or are risk-driven investors just starting to get picky? The AUD and NZD, however, remained steadfast in their fight against the USD. Could investors be looking for those delicious interest rates? Was the AUD and NZD’s significant yield advantage (3% and 2.5% respectively) over their Western counterparts be the basis of their rise? Are carry trades back?! Oh boy – things are really heating up!

The upcoming FOMC interest rate decision could provide the more evidence for us to whether the inverse correlation between equities and the value of the USD is truly broken or not. The Fed is expected to keep rates steady at 0.25%. In their last statement, the Fed expressed their intention to continue to support the US financial market through quantitative easing. We’ve been hearing this statement over and over again, and market players are already at the edge of their seats awaiting more conclusive actions from the Fed. With recent economic data providing some optimism, the odds are stacked against further easing policies.

It seems like people are becoming convinced that an economic recovery is already taking place and it may be high time for the Fed to acknowledge this. Last quarter’s GDP shrank by only 1%, better than consensus of a 1.4% contraction. Improvements are seen all over the housing industry as housing starts jumped by 3.6% in June while construction activity is stabilizing. Unemployment, which is pinpointed to be the US economy’s Achilles heel, slid from 9.5% to 9.4% last month. Nonetheless, the Fed is expected to maintain a cautious stance and is not likely to up its growth forecasts just yet.

In fact, during the release of the NFP report last Friday, some investors came to the conclusion that the Fed would increase its target rate sooner than initially expected, causing the USD to rise. In my book, such speculation is premature as any rate hike would undermine economic recovery. In addition, the idea of a rate hike also goes against the statement of Fed Chairman Ben Bernanke last July 22 where he mentioned that the economy, while showing signs of improvement, remains to be in a fragile condition. He added that the Fed would do all possible actions to sustain such recovery.

Word on the street is that the Fed is set to buy up to $300 billion of longer dated US government bonds expiring on September. This is added to the $1.45 trillion of mortgage debt purchases by the end of 2009. Should the Fed play down the prospect of a rate hike and give room for further QE measures, we might see another USD sell-off. On the other hand, the Fed could paint a rosier picture of the US economy. The question is: Would the underlying fundamentals and the possibility of a rate hike boost the USD or would the economic developments plus the prospect of further QE bring the USD down? Stay tuned for the FOMC rate statement airing Wednesday 6:15 pm GMT!