A Stock Market Held Hostage by the Dollar

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 15th 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.

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.

Michael Pento is a Senior Market Strategist with Delta Global Advisors and a contributor to greenfaucet.com

Comments

[Sundialsvc4]

In my opinion, the true conundrum lies in the fact that our nation (in particular) relies far too much upon foreign production at the neglect of its own. This underlying fundamental ... physical boxes, and what's in them, and where what's in them came from ... is in my view the true source of our predicament.

When we embarked upon this "experiment in fiat currency," in essence what we were saying was that "money has value for its own sake." That "money, itself, is a legitimate export." I aver that it simply is not.

Money is the red-blood platelet that permits both the exchange of value and the brief buffering of value over short periods of time. It's what allows you to, for example, buy the seed you need today in anticipation of the harvest of tomorrow. But what happens if that harvest does not come, or if you declare that it doesn't really matter whether the harvest comes or not? Well, you just invented "futures trading." And the farther-away you get from the reality of that farmer's fields, the more you have "just a tulip."

I believe that both the stock market and the dollar are reflections. We plainly see turmoil in our mirror, but the fault is not of the mirror itself. Nor can the trouble be remedied by "fixing the mirror."

What I -do- know is that this nation, not fifty years ago, produced for the world.

[Veri]

Hey, Rube. As the dollar is rising in value, commodity prices are falling. What is your problem with that? That means food, gas, and other commodity prices are falling. And, I see you mention hedge funds. Losing your shirt are you? As the propaganda in school told us, so many years ago, capitalism brought down prices. Only during periods of deflation does this become apparent. And deflation is very bad for capitalism as far as profits are concerned.

Another item of interest is that you talk about markets as if that was all there is too life. You sound like some Ivory Tower professor, as usual, characteristically divorced from reality. Stop giving your opinion, which is weak and transparent, and start caring about your fellow man. Humanity is not here to benefit you, we are all here to benefit each other.

Finally, this current financial disaster was allowed to happen. What, would you be willing to call Greenspan and just about every other economist, dumb? Almost no one did not know the consequences of the policies of The Fed and the outcome. Instead, the so-called professionals allowed themselves to be blinded by greed. Basic human nature.

Your proposals are weak. They have already been considered and discarded as not beneficial to the few who truly gain from current global economic conditions.

[Michael Pento - Huffpost Blogger]

The conundrum is that the dollar is rising while stock prices are falling, that is not the usual case. Having the dollar rise while commodities fall is wonderful, if the dollar is rising for good reasons. Today the US dollar is rising not because of a diminished supply or rising real rates but because of an unwinding of a hedge fund trade.

I was one of the few who consistently called for the abolition of the Fed and a return to a gold standard.

I actually agree with your contention that we are here to benefit our fellow man but what does that have to do with this commentary.

[Veri]

The dollar is rising because investors are putting their currencies into America. Consider that America is the bed where the world hides their cash in economic downturns. The more foreign currency put under the bed (America), the greater the value of the dollar.

NPR had a great presentation about this effect. I call for the abolition of The Fed. The Gold Standard? There is not enough gold in the world to conduct trade on such a truly global scale as practiced today.