My Two Cents on the Dollar

The stock market is again beholden to the dollar. The Dollar Indexhit a 52 week low recently, but as it began rallying after the FOMC report yesterday, stocks weakened.

It happened again today: as the existing home sales numbercame in weaker than expected, the dollar rallied again, and stocks dropped. When the dollar stabilized mid-morning, so did stocks.

How long will this last? It may last for a while. What matters with currency trading is interest rates, and the Fed clearly indicated yesterday there is little chance interest rates are going up any time soon. This gives currency traders carte blanche to go sell the dollar relentlessly, borrow dollars cheap and use it to buy higher yielding assets.

But why did the dollar rally on a weak existing home sales report? Normally, a poor economic report would indicate that the Fed would keep rates lower longer, which would support a weak dollar.

The reason is that there seems to be a new type of trade: the dollar has replaced the yen for the carry trade. Slideshows:

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  • The carry trade-which involves borrowing a cheap currency and using it to buy higher-yielding currencies or assets-thrives in an atmosphere of optimism on the global economy. That's because the wider the spread, the more attractive the trade is.

    Whenever negative economic numbers come in, traders sell the carry trade, which in this case means buying the dollar.

    As a result, the dollar is now directly correlated to what could be called the "risk trade."

    Most traders believe the Fed will continue to devalue the dollar to get the economy going, even though they are preaching exactly the opposite.

    Of course, despite all the protests of the macro economists, traders know that a weak dollar is generally good for stocks, as long as we can continue to finance our deficit.

    What about the worst case scenario--a collapse of equities AND the dollar? If there is a total rout of the dollar in an unorganized way, and the Treasury market begins to fail, then it's certainly possible.



    Questions? Comments?