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For the past year, the “risk on”/”risk off” trade dominated the markets. When risk is on, investors sentiment is good, so stocks, commodities, and higher yielding currencies rally, while the dollar drops. When risk is off, the opposite happens.

At least that was the case until recently. But something is changing. In the past, the euro also rallied under “risk on” environment. In other words, the euro had a strong correlation with other “risk on” assets, such as the S&P 500 and the Australian dollar.

But the correlation is breaking down. Take a look at the daily chart of those three assets below.

Notice that recently, the equity market and the Aussie have been moving up, while the euro is dropping like a rock. What’s going on here?

There are 2 possible interpretations:

1) The drop in the euro suggests the situation in Europe is much worse than expected. Soon all hell will break lose, and the euro will drag the S&P 500 and the Aussie down in a classical “risk off” move.

2) The drop in the euro suggests the ECB is embarking in its version of money-printing, which is good for risky assets, such as stocks and the Aussie. So the euro could fall even in a “risk on” environment.

The correlation breakdown suggests the market favor interpretation #2. So we could continue to see traditional risky assets rallying, despite the collapse in the euro.

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