Stock Market Held Hostage by the Dollar

By Michael Pento | November 14, 2008 | 4:27 PM | 4 Comments

In ordinary times a strengthening US Dollar would be a propitious sign that the domestic economy and stock market are healthy.  In fact, a strong currency is essential to bring about stable prices, low interest rates, and sound economic growth. But in today’s artificial and perverse global economy the best short term medicine for the ailing markets would be a weakening U.S. currency, as it would signal the return of the Yen carry trade.

In a free market economy a strengthening currency should be the product of restricted monetary growth, positive real interest rates and having a current account surplus. None of those conditions are currently realized today in the United States. So why has the US dollar rallied 21% since mid July against a basket of our 6 largest trading partners? Because of the watershed epiphany reached by the hedge fund community that caused the Yen carry trade to be temporarily suspended. These fund managers had enjoyed a multi-year bonanza from shorting/borrowing the perpetually weak Japanese Yen and buying stocks, higher yielding currencies and commodities which were in a secular bull market.

That gravy train ended abruptly with the realization that the U.S. was highly successful at exporting Mortgage Backed Securities (MBS) to other countries and that many of their banks suffered from the very same ills that plagued our domestic financial institutions. In addition, these global economies were inextricably linked to America’s fortunes and also entering into a recession which would cause their central banks to lower rates aggressively.

When the trade went against them they were forced to unwind their positions simultaneously, these funds had to liquidate their holdings of stocks and commodities across the globe (especially those of higher yielding commodity currencies) and buy back the now rising Japanese currency. This forced liquidation phenomenon is still occurring today albeit in its final phase—investors have until November 15^th to notify hundreds of funds if they want their money returned by the end of 2008. Under this deadline, hedge fund managers are being forced to sell commodities, international equities and currencies such as the Australian dollar to meet these expected redemptions.

The bottom line is that investors are eagerly anticipating the cessation of this forced selling and the return of risk appetite. But that means Instead of desiring a continued strengthening U.S. dollar based on strong fundamentals—which is the real long term solution for providing a healthy economy—they are hoping institutional investors recommence the Yen carry trade as soon as possible. To be specific, this means that once again; oil and gold prices must rise while the U.S. Dollar falls in order for markets to make a significant advance.

Strange I know, but that is the situation that occurs when you have global central banks (especially the bank of Japan) competing to bolster exports and inflate their economies into prosperity by weakening the currency. Outcomes from that phenomenon have been the creation of global asset bubbles and inflation. When something occurs to interrupt that process it can have severe repercussions. To prove this point take a look at the following charts:

 

 

 

You can clearly see that since July the U.S. dollar began to rise corresponding with the S&P 500 (AMEX: SPY)’s and the CRB Index's retreat. They have displayed a very high level of correlation during the past eight months. I’m not sure when stocks will again be able to rise along with a strengthening currency as is the normal relationship. But for now a new paradigm has been reached where a rising U.S. dollar is indicative that risk appetite has diminished, causing stock prices to fall. This is not a coincidence; it is a direct result of the temporary reprieve in global hedge fund speculation.  Such are the ramifications of our now 37 year global experiment with a fiat currency.

Big hole in the deflation argument I don't know how this will play out, whether we vill have inflation or deflation, but it seems to me that the deflationist camp's arguments aren't exactly flawless. They always say that we must avoid deflation at any cost because if we have falling prices people will stop spending (leading to a deflationary spiral). I have two problems with that argument: 1. Prices have been falling for flat screen tvs, cell phones, computers etc for decades and people kept buying like crazy! 2. In Japan the deflation never even reached 1% per year. Do the deflationists actually mean that japanese consumers stopped spending because they knew they could buy the stuff at less than 1% lower prices the next year? Keep ut the good work, Michael! Submitted by Matt (not verified) on Tue, 2008/11/18 - 11:24am » reply |

Deflation / Dollar Bull I believe the Dollar strengthening is a direct consequence of deflation and the drying up (actually more like vaporization) of global liquidity. Asset price deflation is merely the precursor to overall deflation. Once the unemployment rate gets up into the double digits we will begin to see deflation reveal itself in the general level of prices. The Fed's efforts to reflate the economy are proving to be in vain. The monetary base may be increasing, but that only translates to an increase in the total supply of Dollars, if the banks decide to lend that money to borrowers who in turn spend it. The M2-to-Base ratio is collapsing and I believe it will continue to do so. The Fed has absolutely no control over the paradigm shift in consumer behavior. Cash is being hoarded by both banks and consumers alike. I do however, believe that the Dollar is overextended at this point from a technical perspective and needs to consolidate some of its gains before proceeding. Submitted by Bulleri on Fri, 2008/11/14 - 8:06pm » reply |