What A Stronger US Dollar Means for the Stock Market

US markets were up strongly overnight as the major banks passed the annual charade known as the Federal Reserve’s ‘stress test’ of the financial system. The Dow and S&P 500 reversed yesterday’s losses, rising 1.47 and 1.26% respectively.

Weaker than expected retail sales gave the rally a boost, as the bad news lessened the chances of an imminent rate hike in the US. For now at least, we’re back to a ‘bad news is good news’ market.

The idea that the Fed can correctly model financial market behaviour in a crisis is a joke. But everyone believes that everyone believes it, even though know no one really does. When the Fed gives the banks a tick of approval then, everyone buys because they know everyone else will too.

Don’t you just love this market?

The weaker than expected retail sales in the US put a very small dent in the US dollar rally, which may have given the market a boost too. As I explained earlier this week, a strong US dollar is a sign of tightening global liquidity. At some point, dollar strength is going to hurt someone, somewhere, and the dominos could start falling.

Who knows where that point is? But it’s out there somewhere. Ambrose Evans-Pritchard writes in the UK Telegraph:

Contrary to popular belief, the world is today more dollarized than ever before. Foreigners have borrowed $9 trillion in US currency outside American jurisdiction, and therefore without the protection of a lender-of-last-resort able to issue unlimited dollars in extremis. This is up from $2 trillion in 2000.

The emerging market share – mostly Asian – has doubled to $4.5 trillion since the Lehman crisis, including camouflaged lending through banks registered in London, Zurich or the Cayman Islands.

The result is that the world credit system is acutely sensitive to any shift by the Fed. "Changes in the short-term policy rate are promptly reflected in the cost of $5 trillion in US dollar bank loans," said the BIS.

When the Fed was on its monetary easing path, it was all about supporting the US economy. It didn’t seem to care that the flood of liquidity provided by QE was having a massive destabilising impact on emerging market credit systems.

Will it have the same indifference on its tightening path? I’m guessing not. The strong dollar is a form of monetary tightening. The US dollar bull market already has strong momentum. It’s being fed further by the need for foreign companies to hedge their exposure in the derivatives market, which leads to more US dollar buying.

This gives the Fed yet another excuse to delay its tightening path, or at least take steps so lightly that it will be years before you see any sort of interest rate normalisation.

Another flow on effect of this stronger US dollar and tightening liquidity is the weaker demand for US government bonds by foreign central banks.

The Telegraph article continues:

The added twist is that central banks in the developing world have stopped buying foreign bonds, after boosting their reserves from $1 trillion to $11 trillion since 2000.

The Institute of International Finance (IIF) calculates that the oil slump has slashed petrodollar flows by $375bn a year. Crude exporters will switch from being net buyers of $123bn of foreign bonds and assets in 2013, to net sellers of $90bn this year. Russia sold $13bn in February alone.

China has also changed sides, becoming a seller late last year as capital flight quickened. Liquidation of reserves automatically entails monetary tightening within these countries, unless offsetting action is taken. China still has the latitude to do this. Russia is not so lucky, and nor is Brazil. If they cut rates, they risk a further currency slide.

For years, global central banks, especially emerging markets, have absorbed outward US dollar flows and liquidity by buying up US Treasury bonds. These bonds go into their banking reserves and form the base for their own monetary expansion.

It’s been a long, secular process and it’s now coming to an end. When they start selling these reserves, it leads to credit contracting in their own banking systems.

This could have major implications for the US bond market and financial system in general. It may not show on the surface for a while, but there are some major undercurrents happening.

So far, markets don’t see it as a problem. At some point they will.

Aussie shares sure aren’t perturbed. They got in ahead of the US stock surge overnight, rallying strongly yesterday despite the previous day’s weak lead from Wall Street. Positive employment figures for the month of February gave the market (and the Aussie dollar) a boost.

Despite this, the long term outlook for employment remains poor. There will be massive job losses in the years to come as the labour intensive LNG construction projects wind down and move into production phase, and the major car makers leave Australia in 2017 at the latest.

Given the weak outlook for capital spending, it’s hard to see where enough new jobs will come from if the unemployment rate is to at least remain stable.

But the market has a much shorter term focus than that, so yesterday was a ‘good news is good news’ day for investors. More broadly, it looks like the market is in for a few weeks of consolidation.

That is, a rally here, a sell-off there, but not much happening overall. That’s what usually happens after a strong rally, and the Aussie market certainly experienced that in the first two months of the year.

I’ll finish off today with a quote from one of my heroes, the Roman Emperor and Stoic philosopher, Marcus Aurelius. It’s from the book, Meditations, which was really just a series of thoughts he wrote to himself while guarding Rome’s borders against the barbarians to the north.

It’s a quote that could equally be directed to Joe Hockey after his insane idea to let youngsters raid their super to buy into a property bubble. Research by the accounting firm PwC reckons the insanity could knock a $31 billion hole in the budget by 2050.

If you want to get a conversation started Joe, start with something intelligent, not a cynical idea for votes.

Over to you, Marcus:

‘When you are crying for votes on the platform, my friend, are you forgetting the ultimate worth of it all? “I know; but these people set such store by it.” And does that justify you sharing in their folly?’

That was written about 2,000 years ago. Things change, human nature doesn’t.

Greg Canavan,
for Markets and Money

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Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

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