With the death of risk aversion trades, the forex trading market has broken with its previous behaviour patterns and the search for its new one has begun. Here is one possible scenario.

In mid-July 2008, investors abandoned every variety of risky assets, including equities and commodities. They bought U.S. dollars and sold almost every other global currency, parking their capital in U.S. Treasuries to the extent that upon several occasions, the yield on the three-month note dropped below zero. However, toward the end of October, the raw panic declined and currencies dithered, seeking a new balance.

The risk aversion trading play initiated in early February 2009 with a strong inverse correlation between USD and equities, particularly the U.S. S&P 500 index. When equities and commodities gained on rising investor risk appetite, USD lost against a basketful of currencies, including the commodity dollars of Australia, Canada, and New Zealand. When dreadful economic data convinced investors the sky had not yet completed its collapse, they sold these risky assets and scrambled for the safe haven currencies such as USD, the Swiss franc, and in particular the Japanese yen. Simply phrased, equities up, USD down, and vice versa.

In the past week or so this correlation has broken. Despite a two-day sell-off in U.S. equities on 21 and 22 May, USD weakened noticeably across the board, falling to year-to-date lows against multiple currencies. The correlation break was attributed to S&P’s downgrading of the U.K. credit rating to negative outlook, which by extension would also taint the U.S. as both nations are following the same quantitative easing and overspending path. But if that was indeed the case, then one would expect GBP to also depreciate; however, it did not.

A second theory is that the forex trading market is reacting to the potential devaluation of USD based upon the massive debt being incurred by the present administration. Such a devaluation is currently China’s worst nightmare, with their extensive foreign reserves held in USD and Treasuries, which could be rendered less valuable by a steep inflation run, which in turn could be an unfortunate side effect of the Fed’s future unwinding of their QE positions.

Whatever the cause of current USD weakness, the fact remains that China is diversifying its reserves into other currencies and into hard goods, including commodities such as crude oil, coal, and iron ore. This cannot help but be USD negative, and if commodities prices continue to rise then forex traders are advised to look for potential USD depreciation, particularly against CAD, AUD, and NZD, the currencies of nations that stand to benefit the most from any potential commodity play with China.

Rising commodities prices, on the other hand, would of course feed into the very inflation theme that China is seeking to avoid, and if a commodities price spike similar to the one that formed in mid-2008 takes shape, this play could peter out.

This is of course a long-term theme. In the shorter term, the current round of USD depreciation appears overstretched and due for a possible correction. As always, forex traders are advised to keep their stops tight and trailing to lock in profits.