Euro, stocks moving in tandem, but for how long?

By Steven C. Johnson – Analysis

NEW YORK (BestGrowthStock) – The euro has again become a handy barometer of market risk appetite, but the correlation between stocks and the currency could unravel if Europe’s debt woes fail to spark a global crisis of confidence.

Over the past two weeks, the euro, as measured against both the dollar and yen, has moved in the same direction as the S&P 500 index in all but one trading session.

On days when the euro fell (Read more about the trembling euro. ) sharply — it tumbled to a four-year low under $1.22 and an 8-1/2-year trough below 109 yen last week — world stocks plunged with it.

Markets fear that if some European countries fail to repay their debts, the European banks that lent to them will take a big hit, stressing the world banking system and slowing economic growth in the euro zone to a crawl.

That could hurt the world economy, especially if it cuts U.S. and Chinese exports to Europe. Investors would likely continue to sell stocks and the euro in such a scenario.

For now, though, evidence that the euro zone’s problems will plunge the entire global economy into recession is scant, and investors are cautiously attempting to buy growth-oriented currencies and assets while still shunning the euro.

Samarjit Shankar, managing director of global FX strategy at BNY Mellon in Boston, said “real money investors have been nibbling pretty steadily at risky exposure in the past few weeks” despite the anxiety surrounding Europe.

“The managers we talk to, they believe that Europe’s problems could drag on growth, but few think it’s going to entirely derail the world economy by any means,” he said.

Still, investors have shown a proclivity to retreat to the correlative trade with each new scare. The sum of investor fears hit markets Tuesday as the euro and equities fell after the European Central Bank warned of more euro-zone bank write-downs and China’s factory output slipped. But when stocks recovered on strong U.S. economic data, the euro followed suit, trimming most losses against the dollar.

EURO CARRY TRADE?

French bank BNP Paribas expects the euro to fall to parity with the U.S. dollar by early 2011, but senior strategist Sebastien Galy says they are betting that the correlation between the euro and stocks will fray.

Galy says expect investors to start using the euro as a funding currency to finance purchases of more lucrative currencies and assets.

Known as the carry trade, this strategy has in recent years involved dollars and yen. But Galy says the euro will likely replace the dollar, since euro-zone interest rates should stay at record lows longer and the European Central Bank may be forced to take even more extraordinary measures to support European banks and prevent a debt crisis from worsening.

That will keep pressure on the euro but should increase prices of other assets, including stocks and higher-yielding currencies like the Australian dollar or Norwegian crown.

What’s more, if the world doesn’t slip back into recession, investors will have to search for yield wherever they can find it, analysts say, and that tends to favor stocks.

“When cash makes you practically nothing, and when a 10-year Treasury yields you little more than 3 percent, where are you going to put your money?” asked Dean Popplewell, chief currency strategist at OANDA in Toronto. “Fixed income isn’t going to do it, so that’s why there will be support for equities on pullbacks.”

EURO SHORTS

Complicating things further could be the sheer size of bets against the euro. Speculators’ short positions against the euro reached an all-time high in May and remain elevated, according to the Commodity Futures Trading Commission.

That makes those positions vulnerable to a quick reversal, known as a “short squeeze,” as seen on May 19 when talk of possible European Central Bank intervention to support the euro wiped out some of the weaker speculative positions and pushed the euro above $1.26 from around $1.22 on a day when stocks fell sharply. A similar short squeeze was seen last week when China denied reports that it was planning to reduce euro holdings.

Such temporary moves, coupled with anxiety about Europe’s debt situation, have added to short-term volatility, making it tough to predict how assets will trade relative to one another in the short run, analysts say.

But if the euro does become entrenched as a funding currency, markets may have to get used to it moving in reverse correlation with stocks and other risky assets.

Of course, if Europe’s ills start to infect the United States and China, dollars and Treasury debt may suddenly become the most desirable assets, pushing the euro and stocks into lock-step formation again.

Investment Tools

(Editing by Padraic Cassidy)

Euro, stocks moving in tandem, but for how long?