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Wed Preview: Pause in Carry Trades Could Boost Dollar

The floor under stocks feels a bit shaky, and the market could give way to more profit taking this week.

Stocks were mixed Tuesday, as investors chiseled away at technology stocks, a key foundation of the market's rally. The Nasdaq, as a result, tumbled 25 to 2116, while the Dow rose 14 to 9856. The S&P 500 fell 3 to 1064. IBM's announcement that it.

At the same time, buyers rushed into bonds, after a strong 2-year auction showed good demand for bonds. The dollar rose, in contrast to the many days lately where it lost ground, resulting in a rise in stocks and other risk assets.

'Carry' On or Over?

David Malpass, president of Encima Global LLC, thinks the so-called "carry trade" may be ready to take a pause and that could be a temporary positive for the dollar.

"People have been buying everything. There are two components to that. One is plentiful liquidity, zero Fed funds rate, and global liquidity. The second thing is the assumption of a pretty strong global recovery. I think we'll see weakness in the fourth quarter in the U.S. so that will soften this carry trade and cause a pause in the dollar trade," he said.

As a result, equities are also likely to "pause." Malpass said he does not expect a big sell off. "It will be something like the July retracement," he said. But by the end of the fourth quarter, he sees the dollar again in decline and risk assets, like stocks and commodities, moving higher.

Malpass expects Thursday's GDP report to show third quarter growth of 3.2 percent, but the fourth quarter will be another story. He is estimating zero to 1 percent growth in the fourth quarter. "The bigger issue is that the fourth quarter will feel weaker than third quarter," he said.

"The third quarter was puffed up by the clunkers and manufacturing cycle," said Malpass. He said he does not expect a double dip, and growth will improve in 2010.

"This is less than a double dip. We're in a 'U' and the third quarter is an aberration," he said.

What to Watch

Durable goods data for September is expected at 8:30 a.m. and is the second biggest piece economic report this week, after the third quarter GDP report, due Thursday. New home sales are released at 10 a.m.

There is another big auction of Treasurys at 1 p.m., this time $41 billion in 5-year notes after Tuesday's $44 billion in 2-year notes. On Thursday, $31 billion in 7-year notes are auctioned.

"Of the three auctions, I'm most worried about the 5-year, especially after today's powerful run," said Cantor Fitzgerald's George Goncalves, who heads fixed income rates strategy. The 5-year was yielding 2.382 late in the day. The 2-year was yielding 0.983 percent, well above its day low of 0.921 percent.

Goncalves said there was a lot of demand for the 2-year among direct bidders, or the dealer community. Typically, the next auction also goes well when that happens.

Fed Chatter

There've been several news reports about the Fed mulling changes to the language in its statement, specifically about holding rates lower for an extended period of time. Those reports have sent ripples through the Treasury and currency markets, where traders wonder if the Fed is ready to strengthen language about a return to a more normal rate environment, a move that could boost the dollar.

Malpass said he thinks it's unlikely that particular language will be changed when the Fed meets next week. "I think they'll leave in 'extended period,' and they'll find some other way to get a little bit of the dovishness out of the statement, and that will be a minor plus for the dollar," he said.

Goncalves said it was not a factor in the market Tuesday. "Someone was so interested in buying the 2-year today that they don't seem to care if the Fed changes the language," said Goncalves.

What Else to Watch

There are still plenty of earnings to watch Wednesday morning.

ConocoPhillips, Ashland Oil, General Dynamics, Hess, Southern Co, WellPoint, International Paper, Sealed Air, Owens Corning, Newell Rubbermaid, and Arcelor Mittal report ahead of the opening. After the close, Aflac, Owens-Illinois, Symantec, Express Scripts, Equity Residential, First Solar, Akamai, Ryland and Companhia Vale Do Rio Doce release results.

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Yahoo holds an analyst meeting at 11 a.m. Visa could get some interest after reporting better-than-expected results after Tuesday's close. The company reported profits of $514 million or $0.69 per share.

Trillions or Just Billions?

Goldman Sachs equities strategists earlier this week threw some cold water on the idea that the trillions in "sidelined" cash will flow into the stock market, acting as fuel for the rally.

Many analysts have eyed the $3.4 trillion sitting in money markets, with just that view. Yet, Goldman analysts say they think only a fraction of that pool of cash is potentially going to move into stocks, and they calculate that amount to be about $600 billion over a 12-month period. While bullish for stocks, those funds are insufficient to keep the market rally going without improvements in the economy and corporate earnings, they said.

They based their calculation on assumptions about the holdings of individuals, institutions and corporations. They expect that individuals have about $300 billion available to put into stocks of the $1.9 trillion they hold in money market funds. They estimated individuals will shift a total $600 billion out of money market funds but $300 billion of that will flow into corporate bonds. Individual assets in money market mutual funds have fallen by $270 billion since the peak in February 2009.

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Another $150 billion could come from hedge funds and foreign investors, and $100 billion could come from corporations from buybacks, pension contributions, equity issuance and cash mergers and acquisitions. They also point out that stock mutual funds no longer have the high cash levels of several months ago, and that those funds have lost about $9 billion in net outflows, even as stocks moved higher.

Bad Mood Consumer

Consumer confidence numbers, released Tuesday, showed a surprise drop in confidence in October, as consumers continue to worry about job losses and the struggling economy. So it's not surprising that the latest WSJ/NBC News poll shows an increase in pessimism about the economy, after improvement in September. Fifty-eight percent say the economic slide still has a ways to go, up from 52 percent in September.

The poll also showed that 52 percent think the country is headed in the wrong direction, the first majority reading in that category during the Obama presidency.

  • Patti Domm

    Patti Domm is CNBC Executive Editor, News, responsible for news coverage of the markets and economy.

  • A CNBC reporter since 1990, Bob Pisani covers Wall Street from the floor of the New York Stock Exchange.

  • CNBC Senior Commodities Correspondent and Personal Finance Correspondent

  • JeeYeon Park is a writer for CNBC.com. Follow her on Twitter: @JeeYeonParkCNBC

  • Rick Santelli joined CNBC Business News as an on-air editor in 1999, reporting live from the floor of the Chicago Board of Trade.

  • Senior Producer at CNBC's Breaking News Desk.