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Correlations Tight As Dow Meltdown Triggers FX Crash

Correlations Tight As Dow Meltdown Triggers FX Crash

This is one of the busiest trading weeks of the year, and for this very reason, volatility in the stock market as measured by the CBOE Volatility Index rose to its highest level in four months. The Dow Jones Industrial Average tumbled more than 900 points intraday, settling down 600. The S&P 500 dropped 1.7%, recording its worst day since May. While the Federal Reserve has a very important monetary policy announcement on Wednesday, it wasn’t the Fed meeting that triggered the decline. After subdued inflation and employment reports, economists did not expect aggressive announcements from the central bank. Instead, worries about China and the debt ceiling sent equities and currencies tumbling lower. China’s Property giant Evergrande (HK:3333) is at the brink of $300-billion default, and investors are worried about contagion, as there are significant Western bond fund exposure. 

 

September is traditionally a terrible month for stocks, and after focusing on COVID-19 for more than a year, Evergrande is a fresh shock that could trigger major liquidation over the next few weeks. Market correlations that broke down throughout the year tightened instantly, with the sell-off in stocks driving currencies, bond yields, oil and crypto sharply lower. The breadth of risk aversion is astounding. 

 

In FX, the Japanese Yen and Swiss Franc were the best performers, which is what we’d expect to see when stocks fall sharply. The U.S. dollar traded higher against all of the major currencies except for euro, which was unchanged; the Japanese Yen and Swiss Franc. If stocks continue to fall tomorrow, with the Dow dropping 500 points or more, Fed taper talk on Wednesday pretty much goes out the window. In many ways, the Evergrande mess is a bigger deal for the financial markets than FOMC. With China refusing to rescue the property giant, we expect further weakness in currencies for the next 24 to 36 hours. The U.S. dollar is particularly vulnerable to losses against the Yen and Franc. U.S. housing starts and permits are due for release on Tuesday – the housing debacle in China could trigger a more significant reaction to housing weakness in the U.S.

 

Amidst all of the volatility, there are four major central bank monetary policy announcements this week, an election and a long list of important economic data. Canadians head to the polls today to decide if they want to keep Prime Minister Justin Trudeau in power. A month ago, the prime minister called a snap election two years ahead of scheduled. Now, the race is tighter than he could have ever imagined. Although leadership changes typically do not have a lasting impact on currencies, if Trudeau loses, the uncertainty will trigger near-term weakness in the Canadian dollar. The last polls close 7 p.m. Pacific time, so we should know shortly thereafter, but paper ballot counting could delay the results a few more dates.

 

The Australian dollar remains in focus, with the RBA minutes due for release this evening. The central bank decided to proceed with its taper plans at its last meeting, which was a bit of a surprise, but said rate hikes probably won’t happen until late 2024, which was later than most economist anticipated. Although last night’s NZ PMI services report showed a significant slowdown in activity, the government’s decision to ease restrictions in Auckland helped to prevent steep declines in the currency.

 

The euro was supported by stronger inflation numbers and safe-haven bid. Sterling was one of the biggest losers. The Bank of England meets on Thursday and, with no changes expected, the currency is trading primarily on risk appetite. The BoE may be one of the least dovish central banks, but with stocks falling and the Delta variant spreading, it will be reluctant to even talk about raising interest rates. Its furlough program also ends this month, which could lead to some weakness in the economy. 

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