A key correlation in the currency market is breaking down. Here’s what it means

Haruyoshi Yamaguchi | Bloomberg | Getty Images

Something notable is happening between the U.S. dollar/Japanese yen relationship and its correlation with various markets.

Let's start with the dollar's relative softness. Despite some strong U.S. economic data and a much more hawkish central bank stance relative to other G-7 nations, the dollar has been surprisingly weak. Over the last month, the U.S. dollar/Japanese yen relationship has failed to break out above its key 115 level on multiple occasions and now finds itself mired around the 113 mark as markets appear to be at a loss for direction.

To add insult to injury, many of the key correlations between U.S. dollar/Japanese yen and various markets, such as the bond market and the Japanese Nikkei 225, are beginning to break down; the pair is not nearly as responsive to the rise in U.S. Treasury yields or to the gains in the Nikkei.

So, what's going on? The answer may lie in Washington, rather than Wall Street.

High hopes for tax reform have faded, and markets now appear resigned to the fact that legislation will be modest or nonexistent, failing to provide the boost to the U.S. economy that greenback bulls were seeking.

Little wonder, then, that although the market anticipates a 100 percent chance of a rate hike in December, the yield curve out to 2018 suggests a much more muted expectation for future interest rate hikes.

Looking ahead, if the tax reform process fails, as health care did, erosion of investor sentiment could trigger a sharp sell-off in equity markets, which have been grossly overbought for months. Any correction in equities could send the U.S. dollar/yen relationship lower on risk aversion flows.

And although U.S. dollar/Japanese yen is up slightly today as it is finally responding to higher Treasury yields, the breakdown in correlations is troubling, and typically suggests that market sentiment is beginning to change.

For now, the 113 level in the U.S. dollar/Japanese yen looks vulnerable to a test, especially if U.S. equities see some profit-taking at the start of the week. If it breaks support at that level, we may be witnessing the start of a deeper sell-off in the dollar.

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