Watching the USD for clues to equity market direction

In Free by Cam Hui

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Mid-week market update: With stock prices pulling back to test its technical breakout to record highs, it is perhaps appropriate to watch other asset classes for clues to equity market direction, especially on a day when the FOMC made its monetary policy announcement.

From a cross-asset perspective, there is much riding on the direction of the USD. As the chart below shows, the USD Index has weakened after making a high in December. It is now testing a key support zone, as well as a Fibonacci retracement level. Despite the pullback, the uptrend remains intact.
 

 

The other panels of the chart shows the UST 2-year yield and its rolling 52-week correlation with the USD. As well, I show the price of gold and its rolling correlation to the USD. The correlation charts show that the relationship between the USD and these two assets have been remarkably stable. The USD has been positively correlated to interest rates, as measured by the 2-year UST yield, and inversely correlated to gold prices.

As well, please be reminded that gold and equity prices have recently shown a negative correlation. In the past few months, stock prices have risen when gold fell, and vice versa.

With these cross-asset, or inter-market, relationships in mind, what happened to the USD in the wake of the Fed announcement?

Nothing. Sure, the greenback weakened a bit in response to the FOMC decision, but soon bounced back. The same could be said of interest rates, and stock prices.

That leaves investors and traders waiting for a decisive break for clues to stock market direction. Equities are mildly oversold, but my metrics of risk appetite remains in an uptrend. I am inclined to give the bull case the benefit of the doubt, but with reservations.

A mildly oversold condition

Regular readers know that I watch the VIX Index closely for clues of short-term market direction. As the chart below shows, past instances when the VIX Index has risen above its upper Bollinger Band (blue lines) have been reasonably good buy signals. Interestingly, the opposite condition, when the VIX has fallen below its lower BB (red lines), have been less useful as sell signals (see my past comment about asymmetric signals in How your trading model could lead you astray). The market got close to a buy signal on this indicator on Tuesday when it traded above its upper BB, but did not close there.
 

 

I conducted a study of this signal going back to 1990 shows that the market tends to see an oversold bounce under these conditions.
 

 

Even relaxing the rule to the VIX rising above 1.5 standard deviations, instead of the usual 2 standard deviations in BB analysis, showed positive results. Call this a mild oversold condition, which is what happened on Tuesday.
 

 

Indeed, analysis from Index Indicators confirm my assessment of the market’s mild oversold condition. This chart of stocks above their 5 day moving average (1-2 day time horizon) shows a mild oversold reading, with the caveat that oversold markets can get more oversold.
 

 

This chart of net 20-day highs-lows, which is a trading indicator with a 1-2 week time horizon, also shows a mild oversold condition where stock prices have bounced in the past.
 

 

In addition, measures of risk aversion shows that their uptrends remain intact.
 

 

In conclusion, the SPX mildly oversold, risk appetite still bullish, and testing a key support zone centered at 2270. I am therefore inclined to give the bull case the benefit of the doubt.
 

 

However, my inner trader will be carefully watching these bearish tripwires over the next few days.

Disclosure: Long SPXL

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