Rallying Without the Help of China

08/21/2009 12:01 am EST

Focus: FOREX

Kathy Lien

Managing Director and Co-Founder BKForex LLC, BK Asset Management

Stocks and currencies rebounded Thursday (Aug. 20) after the knee-jerk reaction to China’s equity slide. The lack of US data along with a strong performance in oil managed to keep confidence afloat. However, the second consecutive gain in equities is starting to contradict some recent developments. The currency markets have been characterized by severe reversals in early trading that led to predominant dollar weakness. All major pairs show dollar weakness except for the pound and kiwi.

Why the Bounce?

One would expect that with the extreme slide in Chinese markets that the Dow would follow suit. Instead, US markets posted rallies, reversing all of the carnage that the Chinese incident brought about in early trading. There are several factors that lifted the Dow on Thursday, but it was driven mostly by the 4.70% rebound in crude oil. The surprising rally came on the report that showed a large drop in crude inventories. This may suggest that demand has increased, perhaps signaling that consumers and businesses alike are more willing to spend. This would obviously have to be confirmed by more than one instance, but it is a promising sign. Energy shares promptly stepped in to elevate the Dow off of a troubling open. Another factor lifting markets was speculation surfacing about the possibility for a second government stimulus plan. In addition, claims that the recession has ended are steadily mounting. A prominent economist from Goldman Sachs indicated today that he believes the US has officially emerged from recessionary territory. This is right on the heels of the International Monetary Fund calling the end of the global recession yesterday.

Shanghai Spells Trouble for Dow

US markets may have shrugged off the slide in Chinese stocks along with risk currencies, but more attention should be warranted. China’s Shanghai Index has held a very close 80% correlation with US indices over the last few years and has even acted as a leading indicator for major turns in the Dow. In fact, the Shanghai Index bottomed about four months before the US and global equities.

We are at a point where the course between the Dow and Shanghai has largely diverged. The index has shed about 20% from its 2009 highs, which may indicate that a correction phase may start to gain momentum in other countries. The implications are just as important for the health of the recovery trade. The improvement in risk has had a very strong relationship to the Chinese index. Now that the index is falling, any hiccup in world markets could result in a sharp correction in currencies like the Australian dollar. Whichever way you look at it, the substantial drops in Chinese equities are an impending obstacle for other markets to face, and may eventually take away some of the vitality in investor confidence that has flourished in the last month. The fact of the matter is that many are counting on China to pull the world out of the recession. Now we are receiving signs that those hopes may be crushed in what became an overextended Chinese stock market.

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By Kathy Lien, Director of Currency Research at GFTForex.com

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