Breakdown of correlations

Even as markets see-sawed on divergent expectations from Bernanke’s Jackson Hole speech, a strange breakdown in forex correlations emerged towards the end of the week. The dollar’s safe-haven Thursday surge made sense as the German stock market tanked and bets against QE3 increased. But the dismal data that pressured the euro failed to prompt inflows into the Swiss franc and Japanese yen, upsetting the market’s traditional fear gauge.
Also, the fed’s assurance that economic deterioration didn’t yet merit more stimulus triggered dollar weakness versus the majority of its most traded peers, even though the dollar-short script was favoured by pundits anticipating QE3. And while looming threats of BoJ and SNB intervention explain trader reluctance to go long, next week’s data-mine comes at a good time as a groping market looks for direction.
Most important will be US non farm payrolls and German growth. It is difficult to see any meaningful recovery in America with regard to the employment situation. The NFP has been shaky since early ’10, and in the absence of continued growth and unemployment falling below nine per cent (something that has not happened since June ’09), even fed pep talk will fail to lift the greenback against major rivals. Expect continued dollar weakness in most pairs with limited losses against the euro as the European sovereign debt crises worsens.
The European drama, meanwhile, becomes more traumatic every week. Even as German and EU growth numbers are expected to disappoint, investors are more unnerved by the deepening political cleavage in Berlin. Merkel’s fragile coalition is distancing itself from the euro bailout, the Bundesbank is furious over the EU posturing towards ‘transfer union’, the German president is publicly questioning the legality of ECB’s bond purchase program and her CDU party is hemorrhaging core voters over German taxpayers funding peripheral profligacy. These developments are demoralising the ECB, with the jousting threatening delay of parliamentary approval of the July 21 deal, wrongfooting the central bank banking on assurances of the stability fund taking over bond purchases “within months”. There is little chance of near-term respite for the euro as the Merkel-Sarkozy initiative loses steam. This week’s trading is likely to incorporate range-bound mini-trends prompted by periodic data releases as investors with fingers on triggers eye breakouts in most major pairs.