How to play the Fed-driven ‘colossal dislocations’

The U.S. dollar has surged 23 percent in the past year, a move that Societe General strategist Larry McDonald says has led to "colossal dislocations" in the market. That has him looking the other way, and playing stocks for a greenback dip.

Even though the big concern used to be that the Federal Reserve's policies would weaken the dollar by creating inflation, McDonald blames the Fed for the dollar's recent increase in value.

The dollar has risen sharply as the Fed looks to raise rates from ultra-low levels, which would make it more attractive to hold dollars. And the Fed is discussing a rate hike as the European Central Bank embarks on a quantitative easing program that is putting added pressure on the euro.

"Because of how they're going about this, the Fed has created these disconnects and dislocations in the market," said McDonald, SocGen's head of U.S. strategy.

In an interview Wednesday on CNBC's "Trading Nation," McDonald said that has led to the outperformance of sectors less exposed to the rising dollar, like the retail index. The SPDR retail ETF (XRT) has risen 21 percent over the past six months, nearly doubling the performance of the S&P 500.

"Part of the outperformance was driven by the strengthening of USD as investors fly from sectors with international and commodity exposure. The surge in USD has caused significant revenue and profit headwinds for many multinationals that derive substantial sales outside the U.S.," McDonald wrote in a note to clients.

But the strategist says the dollar rally is set to end, because the Fed will not raise rates if policymakers continue to be concerned about the rising dollar.

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"The dollar's strength will create its own demise," he predicted.

So to capitalize on his predicted drop in the dollar, McDonald recommends shorting retail stocks, either outright or versus a long position in more dollar-exposed sectors of the market, such as industrials.

This trade will profit as the dollar-driven divergence trade loses steam, he says.

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