The weak dollar-strong stocks trade—a friend to the market but an enemy of the economy—has been unwinding for the past two months and is adding fuel to hopes that 2011 will be a profitable year on Wall Street.
Since early November, when the Federal Reserve confirmed the second round of its quantitative easing monetary program, the dollar has gained more than 5 percent, while stocks have risen nearly as much.
During much of the post-financial crisis rally of the past 19 months, that would have been hard to accomplish.
But with economic projections next year getting ratcheted upand market optimism reaching a fury, it now appears possible that both the greenback and the stock market can move up together, a trend often seen as positive.
"Just from a very broad standpoint, there are no hard-and-fast rules that when interest rates go up that's bad for stocks and if the dollar strengthens that's good for stocks," says Gary Flam, portfolio manager at Bel Air Investment Advisors in Los Angeles. "You've always got to look behind what's causing either the dollar strength or interest rates to rise. That's what's happening over the last couple of weeks—it's all driven by renewed faith in the US economy."
Since the financial crisis began, Federal Reserve policy has been geared towards liquidity—increasing the money flow in the economy to generate growth. A byproduct of that is a weaker dollar, making US exports cheaper in the global marketplace. It's an effective short-term solution but detrimental over the long term as it usually leads to inflation.
Commodity pricesalso are part of the equation, since they are most frequently priced in dollars and are therefore cheaper to purchase with foreign currencies.
But they, too, have been on the rise, with oil hitting a 52-week high Thursday and others, particularly the so-called "softs" like cotton, corn and wheat, moving higher.
The ability of asset prices to rise in the face of the dollar holding strength against a basket of foreign currencies has strategists even more optimistic about the road ahead.
"You still want it to be the strongest currency in the world. You still want to be the safe haven," says Nadav Baum, executive vice president at BPU Investment Management in Pittsburgh. "That's a sign of strength if the dollar continues to strengthen for the right reason, which is productivity, which is corporate earnings, which is increased dividends, which is M&A activity. If you look at the underlying things happening in the stock market, these are all bullish signs."
Dollar strength has been a curious thing over the past few months, especially considering the Fed and its move toward buying $600 billion of Treasurys in an effort to drive down short-term rates.
Despite the added liquidity, rates actually have risen, pushing the benchmark 10-year Treasury note to near 3.40 percentand to a seven-month high earlier in December. Mortgage rates have climbed as well, seeming to put a damper on hopes that the Fed's moves might ignite the moribund housing market.
Still, a market that operates so much on perception and the duel between fear and greed has chosen to see the developments in a sharply positive manner. In the light of a brighter day for the economy, investor fear of a higher dollar is becoming passe.
"Over the course of the past several months it was amusing that everybody's knee was jerking as the dollar got stronger," says hedge fund manager Dennis Gartman, author of The Gartman Letter. "People became convinced that the only way commodity prices could go higher was if the dollar got weaker. I don't think that's holding true as dramatically as it was a few weeks ago."
Yet too much of a good thing can be bad as well.
A dollar index hovering around 80 is fine, but should it strengthen to 83 or so, that could become trouble, says Richard Hastings, strategist at Global Hunter Securities in Newport Beach, Calif. The index measures the dollar against various foreign currencies but is most strongly weighted on the euro relationship.
"There's a tremendous amount of narrow channel friction that tells me that nobody generally speaking is super-comfortable holding the dollar at more expensive levels," Hastings says. "The evidence from recent months of trading suggests the planet doesn't have enough institutions that get excited about selling tons of euros because there's no excitement about having an expensive dollar."
Similarly, the growth in commodity prices also is seen as reflective of a stronger global economy—to a point.
Should prices get out of hand and start driving price inflation, that would be viewed as a negative.
"At some point oil will be a headwind for the US economy. The fact that it's right at the high end of where it traded the last few years is a reflection of the global economy," Flam says. "Early in economic cycles a rise in rates and strength in the dollar are not cause for concern. As the economy cycle matures, they become more worrisome."