http://www.reuters.com/article/idUSTRE6361PX20100407

- Analysis

LONDON

Wed Apr 7, 2010 8:12am EDT

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A bank employee counts U.S. hundred dollar bills at Kasikornbank in Bangkok in this January 21, 2010 file photo.

Credit: Reuters/Sukree Sukplang

LONDON (Reuters) - The post-crisis relationship between the dollar and risk assets such as stocks and commodities is weakening, a move that may pave the way for the currency to benefit from a favorable U.S. economic outlook.

A break-up in the inverse correlation between the dollar and risk assets, a key feature in the risk rally since March 2009, reflects greater investor confidence in the U.S. economy and expectations the Federal Reserve will lead global interest rate hikes while Europe and Japan struggle with economic woes.

This greater focus on U.S. economic outperformance and the prospect of higher rates will encourage investors to buy dollars even as risky assets rally.

Over the past year good U.S. economic news has tended to ignite "risk-on" buying of stocks and commodities and dollar selling as investors bet improving risk appetite would push capital from U.S. markets to higher-yielding assets abroad.

But that dynamic appears to be changing. A case in point was the dollar's reaction to Friday's robust and risk-friendly U.S. jobs report -- the currency rose broadly as markets priced in a quarter-point Federal Reserve rate hike in September.

"Our hypothesis is that the risk-on/risk-off matrix that seemed to dominate market development during much of the crisis is breaking down," said Marc Chandler, strategist at Brown Brothers Harriman.

"We suspect it is being replaced by a greater emphasis on country specific macro-economic developments."

According to Reuters data, the 90-day correlation between the S&P 500 index .SPX and the dollar index .DXY has fallen to zero over the past month -- showing there is no relationship -- from around -0.9 in December, reflecting the new dynamic in which the dollar can rise independent of moves in risk assets.

The correlation "coefficient" number varies between -1 and 1, with 1 showing perfect correlation -- two assets always moving in the same direction -- and zero showing no relationship.

The 90-day correlation between the Volatility Index .VIX -- a key gauge of risk aversion -- and the dollar has fallen to -0.14 from a high 0.89.

The shift in the dynamic is also happening as the euro zone suffers from a debt crisis and Japan's stagnant economy is pressuring the Bank of Japan to maintain its super-loose monetary policy -- negative factors for the euro and yen.

"We've seen the U.S. economy continue to recover and it looks probably the most healthy economy in the developed world and that's helping to support the dollar. We have problems everywhere else," said Phyllis Reed, head of economic, currency and fixed income research at Kleinwort Benson.

The post-crisis relationship, which saw stocks and commodities rise at the expense of the dollar, coincided with a broad risk asset rally between March to December 2009. And the new phase, which is gathering pace, may last for some months.

"These correlations last about 6-12 months, averaging about 9 months. I can imagine this kind of phase lasting for most of the year," said Terence Mall, head of multi-asset strategy at Investec Asset Management.

DOLLAR/COMMODITIES TIES

Commodities and the dollar have shown a long-standing negative relationship -- where a weakening U.S. currency leads to higher commodity prices by creating demand for dollar-priced resources.

These ties strengthened late last year as capital exited U.S. money markets in search of higher yielding assets. The safe-haven U.S. money market saw nearly $300 billion of outflows in the first quarter alone, according to fund tracker EPFR.

But that flow might peter out soon if the U.S. economy becomes a source of growth and related risks that bring reward.

The latest mutual fund data analyzed by UBS shows U.S. funds further reduced the share of foreign assets in their portfolios to 25.2 percent, marking the fourth month of decline since the October peak of 26 percent.

The breakdown of the correlation may also mean, however, that it may be some time before the dollar decisively breaks higher.

"The dollar may be in a bit of a holding pattern near-term, not declining materially on increased risk sentiment as better economic data will support a Fed rate hike," the Swiss bank said in a note to clients.

"And not strengthening materially either until more certainty in the timing of the initial Fed rate hike emerges."