Why Are Investors So Worried About A Stronger US Dollar?

Investors are starting to worry about a stronger US dollar—despite reassurances from policymakers that interest rates will remain low for some time.

Stocks have depended on a weak dollar to stage a 60 percent rally off their 2009 lows, and investors view a disruption in that trend as poison to equity prices. Commodities—especially gold—have also seen a boom this year as the weaker dollar made those investments more attractive.

The US currency began rebounding Friday after the government reported that job losses were much smaller than expected in November. The prospect that the economy was stronger than many thought fueled speculation that the Federal Reserve could start raising interest rates ahead of schedule, making the dollar a more attractive investment—and making stocks and commodities less valuable.

But Federal Reserve Chairman Ben Bernanke appeared to squash the rate speculation on Monday, saying the US economic recovery remained tentative so that rates will remain low for an "extended period."

The dollar did, in fact, fall back from its recent rally after Bernanke's comments. But investors are already looking ahead—and worrying about what a stronger dollar will do to their portfolios.

"There has become an almost bizarre inverse relationship between the dollar and the stock market," says Uri Landesman, head of global growth strategies at ING Investment Management in New York. "If the dollar index rises the market falls. It kind of concerns me because the dollar is pretty technically oversold. You need the dollar to stabilize at some point."

The probability of a stronger dollar pressuring stocks raises another issue beginning to vex investors: When will stocks and the dollar be able to rise together, as they traditionally have done?

"In the US it was fascinating to see the stock market's reaction to the employment data on Friday," David Rosenberg, economist at Gluskin Sheff, wrote in an analysis Monday. "The markets couldn't handle the good economic news very well ... Indeed, this was the second outside reversal session in a row, and leadership is beginning to falter."

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Peter Tanous, president of Lynx Investment Advisory in Washington, D.C., sees the market's lack of enthusiasm over the jobs number as indicative that investors already have priced in positive news and now could begin worrying about the remnants of the financial system collapse. The recent credit crisis in Dubai, for instance, was largely considered an aftershock from the global financial collapse.

In the US, burgeoning deficits combined with a threat of inflation as the dollar rebounds could cloud the horizon ahead, Tanous said.

"The market is becoming impervious to good news as it starts to focus on some of the problems down the road. The commercial real estate debacle is going to start hitting us and that could be really ugly," he said. "The takeaway is the market may be shifting its focus from the good news and towards the potential bad news down the road that could have an effect on stocks."

Consequently, investors could dial back on buying stocks while also looking for safe havens such as inflation-protected securities.

Recent trends suggest retail investors are increasingly selling into rallies, and sentiment surveys are showing growing bullish sentiment, generally seen as a contrarian indicator of the market's direction.

"The dumbest thing anybody can do is pick tops and bottoms because you're always wrong," Tanous says. "Instead of trying to pick a top we look at every portfolio for risk. Inevitably the biggest risk in any portfolio is the equity."

As the dollar-stocks trend faces an uncertain future, analysts are looking at the dollar index and whether the measure is hitting an inflection point.

The index fell during Bernanke speech after being positive earlier in the day and was near its a key moving average Monday, a point that some see as pivotal for a turnaround. The index slipped as Bernanke spoke, indicating some assurance among investors that the US currency wouldn't move much at least in the short term.

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"A stronger dollar should be negative for stocks as the correlation between stocks and the dollar has been negative," Mary Ann Bartels, analyst at Bank of America-Merrill Lynch, wrote in a note to clients. "The US dollar is challenging the 50-day moving average at 75.68. If this breakout holds the next key level for the dollar is 76.82.

"So the tug of war between the bulls and bears is still on, and will be won on a move to break key levels on the S&P of 1,120 or 1,084."

Should the dollar hold its ground, the market could trade in a range or head lower, some analysts say.

"I'm watching it closely but I don't want to make a conclusion from one day," ING's Landesman says. "If (the market) doesn't rally this week, you're probably going to be range-bound at best for the rest of the year."