Dollar slide could be investment "game changer"

LONDON (Reuters) - This week's accelerated U.S. dollar slide may mark a key moment in the world's financial stabilization and economic recovery, indicating a return of stress-free investment patterns that could be self-perpetuating.

Although many false dawns and premature "all-clear" signals have come and gone over the past two years of market turmoil, investors are watching the dollar's drop with great interest.

Its decline -- the first in almost a year -- appears independent of broader movements in equity or bond markets.

After months in which the dollar did the exact opposite of the stock market -- partly on the argument that falling stocks meant greater stress and hence more demand for liquid, safe cash and Treasuries in the United States -- the link has broken down.

On Thursday, for example, the S&P 500 index of leading U.S. stocks was down for the third session in a row and off more than two percent from Monday's close. But the dollar's index .DXY against a basket of major currencies was also down 1.7 percent over the same period.

This breakdown of the high correlations and proxy trading that were characteristic of the most intense moments of the credit crisis may reveal a greater healing of the system.

What is more, if this gradual weakening of the dollar develops into a steady trend, the knock-on benefit for the likes of hard-hit emerging markets are significant.

"The big surprise for people is the declining correlation between equity markets and currency markets -- this is where the breakdown is going to happen," said Momtchil Pojarliev, Head of Currencies at Hermes Fund Managers.

"During the most turbulent periods, markets became very correlated as people were looking for proxies," said Pojarliev. "But now that markets are back to normal there's no need for proxy trades. And with deleveraging now completed from the hedge fund side, correlations are going back down."

CORRELATIONS AND JUBILATIONS

Rising correlations between different asset classes and groups -- most of which sold off in lock-step as the credit crunch raged -- has been disastrous for pension funds and endowment funds who had benefited from highly diversified investment portfolios over the past 20 years.

For hedge funds, it has required re-engineering of trading strategies. As malfunctioning and illiquid credit and derivative markets were often impossible to play, many used still-liquid currency markets as proxy trades to bet on the unfolding crisis.

First of those proxies was to buy Japan's yen whenever stocks and risk appetite fell. The argument was that rising risk and volatility would see an unwinding of huge interest rate carry trades in which the yen was used as a cheap funding currency.

But that correlation broke down in January and February when the yen plummeted even as equity losses mounted.

The second negative correlation trade -- to buy U.S. dollars on equity losses -- coagulated in the middle of last year and intensified in the first quarter. Negative monthly correlations -- where a perfect one-for-one negative correlation would give a reading of -1.0 -- were as high as -0.9 for the first four months of this year.

But as tensions have eased hopes for economic stabilization have lifted equities, emerging markets and commodities and credit and money markets have normalized. This correlation is now being undermined.

"The dollar in the last 24 hours is potentially doing something more interesting here," said Paul Lambert, head of macro strategies at hedge fund managers Polar Capital.

"It's early days, but there is a world going forward where you might have a weaker dollar that could be independent from the behavior of risk."

Lambert said that's a world where the U.S. Federal Reserve adopts an aggressively easy monetary stance and retains that stance longer into the recovery than the market is currently expecting. "In that world, the dollar continues weakening."

The sharp steady decline in implied volatility, which has almost halved from early 2009 peaks for both Wall St stocks and currencies, has been critical freeing up money parked in money market funds and Treasuries.

With many risk management models requiring a decline in volatility before allowing funds to pick up riskier assets, the decline in vol has been profound in drawing out hunkered down U.S. cash back out to work in emerging markets and elsewhere.

Emerging market equities .MSCIEF have outperformed Wall St benchmarks .SPX by almost 30 percent this year.

A falling dollar is an added boon for emerging markets for several reasons -- it enhances the return on dollar-based US investments, stabilizes fixed exchange rate regimes, rebuilds foreign exchange reserves and lifts oil and commodity prices for the big commodity exporters.

RBS strategist Alan Ruskin reckons it is too early to say the link between the dollar and risk appetite for equities and other securities has broken down, but he says there are many arguments for a independently weaker dollar developing.

"The decline of the dollar has developed a life of its own," Ruskin said in a note to clients.

Negatives include the fact that near-zero yields will encourage traders to use the dollar to fund any return to riskier interest-rate carry trades, he said. And second is need for the conservative money parked in U.S. Treasury bills to find a new, more productive home.

Ruskin estimated that between September and March some $150 billion of private money and $297 billion of public money found its way into U.S. T-bills.

"Even modest reallocations can have an outsized impact."

(Editing by Ron Askew)