The sliding dollar means more bad news for markets
By
Dominic Frisby Jul 07, 2010
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There has been a broad pattern to markets in recent years.
As stock and commodity markets have risen, so too have the euro and the pound. The US dollar meanwhile, has fallen.
But when the US dollar has rallied, commodities, stocks, the euro and the pound have all fallen.
But there are signs this pattern may be changing. What are they and what do they mean?
What caused the anti-US dollar trade?
This dollar-down-everything-else-up pattern was so clear in the middle part of the decade that it became known as the anti-US dollar trade. The US monetary authorities led by Alan Greenspan were desperate to re-flate the US economy after the dotcom bust.
They slashed interest rates and encouraged lending. Money surged into assets of all kinds - houses, stocks, commodities. The US dollar, meanwhile, slid from 2002 to 2008, with some respite in 2005.
In 2008, when credit suddenly dried up, money fled out of assets back into the US dollar, and it rallied. But in 2009, as monetary conditions became easy once again, the US dollar fell and we had another boom year in stocks and commodities.
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In the charts below we can see the correlation. The black line shows the US dollar, the red line shows the S&P 500, the green line shows the CRB commodities index, and the blue line shows the euro.
There is some substance to the argument that the boom in commodities had as much to do with loose US monetary policy as it did with actual declining supply.
Patterns are starting to change
But over the last few weeks, this pattern has started to deviate from the norm.
This latest boom in stock and commodities markets ended in late April 2010 and a sharp correction began. The euro was already in decline - this accelerated as fears grew over Greece and its debt. As May turned to June, the panic subsided and the euro made a low of sorts against the dollar of around $1.20.
The dollar simultaneously peaked at about 89 on the US dollar index, which measures the dollar against a basket of other currencies. A relief rally began in stock and commodity markets and - as you'd expect - the dollar turned back down.
But then in mid-June stock markets fell, making a lower low by the end of last week, amongst extremely bearish sentiment. But the US dollar continued its slide. This is not what you would have expected - judging by the past decade, it should have rallied.
So what can we read into this?
It may just be a temporary aberration. The European Central Bank withdrew some liquidity from the market a fortnight ago (see previous Money Mornings for more on this), effectively tightening monetary policy, while at the same time, some awful numbers came in from the US. Perhaps that caused a loss of faith in the dollar which outweighed the 'flight-to-cash' safe haven quality that has buoyed it in recent years.
Or it may be that the continued fall in the US dollar and the rise in the euro is telling us that the slide in stocks is now overdone. Indeed, the CRB commodities index made a higher low in June than it made in late May, which would further confirm that. The anti-US dollar trade may be back on, after the May-June setback.
However, it's worth noting what happened the last time the dollar slid along with stock markets.
Stock markets peaked in July 2007. They made a double top in October that year, and then began to slide. But the dollar didn't start rising at that point. In fact, it carried on falling for another six months, alongside stocks, and only made a bottom of spring-summer 2008. A few months later, in autumn 2008, that slide in stocks became a crash.
The black line shows the US dollar and the red line the S&P 500 during this period.
Crashes are such rare occurrences - you can count the crashes of the last 100 years on the fingers of one hand - that, in terms of probability at least, it doesn't make sense to place large bets on another one.
But it does make sense to be defensive.
I am not saying another crash is coming, but it could. Many of the fundamentals are there.
But I do maintain my stance that this continued volatility is eerily reminiscent of 2008. Yesterday, for example, was breathtaking. When I began this article in the mid-afternoon the Dow was up almost 200 points. By the time I settled down to watch the World Cup, it was negative on the day. These are not healthy markets. There are too many conflicting signals and too much day-to-day volatility. Traders can play the swings to their delight. But those who look at the longer-term should continue to sit in cash, and wait and watch for a better buying opportunity. I am sure it will present itself before the year is out.
Sterling's not looking so bad anymore
As to which currency you should be holding your wealth in, well, suddenly the pound does not look like such a bad place to be. I posted a chart a few weeks back, which identified $1.50 as an inflection point. The pound has broken through that trend line.
I see $1.55 as the next point of resistance, but thanks to this new wave of fiscal sanity up top, this rally looks like it may have legs. We may soon be able to enjoy cheap holidays abroad once again.
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