12/18/2008 05:12 am ET Updated May 25, 2011

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