In the second half of 2008, with risk aversion driving both forex trading markets and equities bourses, a tight correlation developed between the U.S. dollar and shares price indices. In particular, this correlation was sharply developed between the Wall Street S&P 500 index and EUR/USD, caused by investors selling off these stock shares and exchanging their funds for safe-haven currencies, with USD being the main beneficiary of this transaction. When risk aversion rose, shares prices and EUR/USD fell; during times when traders grew cautiously optimistic, both rose.

From mid-December to the end of that month, during the Christmas and New Year’s holidays, this correlation was shattered by lower liquidity. However, by the second week of January it had been re-established as risk aversion continued to drive financial markets. Only recently, within the past five or so trading weeks, has this trading pattern begun to break down, with the more usual fundamental and technical drivers reasserting their influences over forex trading currency pairs.

Examine the four-hour chart of EUR/USD below, noting that the vertical white dotted lines indicate weekly divisions:

For the first two weeks of the S&P 500 rally, EUR/USD rose strongly in correlation, from 1.2560 to 1.3740, crossing above its 200-MA and climbing nearly vertically on 18 March, the day the Federal Reserve announced quantitative easing. However, on the following Monday, 23 March, even as the S&P 500 continued climbing, EUR/USD began trending down within a regression channel. The currency pair’s price has since broken back beneath its 200-MA on four-hour charts and returned to the level it held prior to the QE announcement, roughly 1.2950, at which level it continues to consolidate at the present time. Pressure holds to the downside.

It is possible this disconnect between EUR/USD and the S&P 500 signals a full return to normal trading patterns, with stock indices answering to the usual guidance of corporate profits and earnings, and currency pairs responding to fundamental and technical drivers. However, this disconnect could also signal a potential top forming in the S&P 500 and by extension other global bourses, with a resulting sharp correction and sell-off. As corporate profits remain weak, fundamental data continue to illustrate an ongoing contraction nearly worldwide, and those admirable U.S. first quarter 2009 banking results were heavily influenced by creative accounting and (except in the case of Bank of America) drawing attention away from downside loan portfolio risks, there is little reason to believe that this rally has put a bottom beneath Wall Street.

It is far too early within the ongoing financial crisis and global recession to foretell the final demise of risk aversion trading. As economic and banking problems continue to unfold, the chance of investors’ fear outweighing their normal greed on at least an occasional basis remains high and at such times, safe-haven flows will overwhelm carry and commodity trading, with the resulting disconnect between economic fundamental data and appreciation of USD, the Japanese yen, and the Swiss franc. Forex traders are warned to watch for this ongoing dynamic and follow its distinct trading rules accordingly.