Connecting the Dots in the Dollar Disconnect

Stocks cheered on Tuesday in the largest gain in a year but the response remains lukewarm in FX and bonds. The Canadian dollar was the top performer while the Swiss franc lagged. The focus will be on the Aussie in the hours ahead with the CPI report due. 

The S&P 500 has retraced nearly 61.8% of its losses over the past month but USD/JPY has hardly regained 30%. Even after the best day for stocks in 12 months, the dollar failed to make any gains against the yen.

What's the forex market saying?

Part of the story is Treasury yields. The 10-year remains near 2.22% which is an unattractive level for foreign inflows. What's happened is that bonds and FX are weary of the Fed after Bullard's comments last week, while a more-dovish Fed is unambiguously bullish for stocks.

Expect that correlation to unwind next week and the US dollar to play catch-up if the Fed stays the course on the taper – something that's infinitely more likely with stocks rebounding.

At the same time, the ECB opened a new front Tuesday with a report saying they're considering buying corporate bonds late this year or early next. The usual denials even lacked urgency, saying only they weren't “currently” considering buys. If they do it could add rough 600-800 billion euros to the balance sheet.

The euro underperformed and finished near the session low at 1.2716. The leak on corporate bond buying could be aimed a cushioning the blow related to possibly bad news from next week's AQR and stress test.

Looking to the hours ahead, the focus is on the Australian dollar with Q3 inflation data due at 0030 GMT. The consensus is for a 2.3% y/y rise on headline and 2.7% rise on the trimmed mean. I see minimal reason to buy AUD on a higher number because the sequential changes will still be down significantly and much-lower oil prices put disinflationary pressures in the pipeline.