The following is a guest post from a market strategist at a major research firm . . .


The dollar rallied, did it? That was the “cause” of yesterday’s weakness in the energy and metals commodities, which in turn “caused” the related equities to sell off? Hogwash! Stocks are calling the tune here, folks.

The bond market may have preoccupied U.S. Presidents and Federal Reserve governors in the Eighties, and indeed the threat of higher interest rates always hangs over the stock market like the Damoclean Sword, but today’s policymakers have targeted stocks and spreads (they haven’t had to worry about interest rates since the Asian crisis in the late ‘90’s shocked the Asians into pursuing mercantilist trade policies that require large scale, price insensitive buying of U.S. debt).

If traders flipping E-mini S&P 500 futures are watching the DXY (the Dollar Index) or the EUR/USD cross for clues about risk appetites, then yes, on a day to day basis we can say that a stronger dollar may have “caused” equities to weaken. You can trust, however, that traders flipping DXY futures or euros are taking their cues from the stock market and that as often as the dollar moves the stock market, the stock market moves the dollar (specifically, “the dollar” as it is traded real time against other currencies, commodities, and assets).

We’re not watching one phenomenon (either a weakening dollar, or a rising stock market) occur, and then judging how that phenomenon will affect other markets, we’re watching all markets react in lockstep to policy.

Here’s an easy example: the Federal Reserve Bank of New York bails out AIG by taking its assets onto its balance sheet in exchange for loans and lines of credit. Anyone with a dollar bill in their pocket assumes a tiny bit of AIG’s risk (the Fed’s liabilities are dollars, don’t forget), and, assuming that AIG had to be rescued because its losses made it insolvent, anyone with a dollar bill in their pocket has a dollar bill that is worth a little bit less than it was prior to the bailout. This policy action therefore weakens the U.S. Dollar. Simultaneously, AIG’s creditors, which would have faced massive losses themselves, no longer face these losses. Their share prices rise because they are suddenly worth more. This policy action therefore supports the stock market.

This “policy ethos” has been in place since “the troubles” began in 2007. In conclusion, did the dollar rally “cause” weakness in the stock market yesterday? Possibly. But, does it make more sense to say that ongoing belief in the continuance of a “weaken the dollar, strengthen the stock market, shrink all risk premia” policy ethos ebbed briefly yesterday while from a weekly or monthly perspective it continues to flow? In my humble opinion, definitely.

If you want to know why this policy ethos has been chosen, look no further than the second quarter Flow of Funds report. Of all the frankly frightening, Frankenstein-ian data contained in the FoF (summarized by Doug Noland here), the financial media was buzzing about the $2 trillion rise in household net worth in Q2, the first such rise since 3Q07 (how ironic that the Federal government borrowed at a nearly $2 trillion
annualized pace in Q2!).

Stock market up, household net worth up, confidence in spite of falling wages and rising unemployment up, debt-fueled consumption up, and voila! It’s 2006 again. Or, look no further than yesterday’s comment from Lennar CEO Scott Shipley: “The sense that now is the time to buy is starting to gain momentum as potential qualified purchasers are getting confirmation from news reports and the overall stock market that prices are at or near lows.”

Take an image of Federal Reserve Chairman Ben Bernanke silently wiping a single tear of joy from his cheek as that comment scrolled across his Bloomberg terminal. Too bad about the dollar, though, right? (source: Bloomberg; Federal Reserve; Federated Investors)

Category: Currency, Think Tank, Trading

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

4 Responses to “Let’s get real about dollar-equities causation”

  1. leftback says:

    With all due respect, Mr Strategist at major research firm, you must be kidding. You’re surely not denying that the dollar carry trade exists? This is exactly why the equity market and the currency trade are so intimately intertwined. The fundamentals for crude oil, for example, probably support a price of $40/barrel and the rest is all contributed by dollar hedging. Similar considerations apply to other asset classes.

    It is hard to imagine that anyone with even a limited understanding of how prop desk traders and hedge funds operate could miss the correlations between EUR:JPY and EUR:USD and the equity/commodity/high-yield debt/high-yield currency complex (Risk Assets). The only participants who aren’t using the dollar as the funding currency would be small retail traders, and once they are the only ones in the market it is Game Over.

    You obviously do not trade, or talk to traders other than momentum traders, or you wouldn’t espouse this “cart before the horse” explanation of the present market unless you are being completely disingenuous. This market is ALL ABOUT hot money injected by the Government. The currency and bond markets are enormous and very powerful. The equity market is merely a highly visible pimple on the elephant’s arse.

  2. Pat G. says:

    First of all, in yesterday’s market the dollar fell and commodities rose. Second of all, “the financial media was buzzing about the $2 trillion rise in household net worth in Q2″ which was predominately about the rise in the stock markets since their March lows. That rise has been based on ” Ex-Moody’s Analyst: Inflated Ratings Continue” and cost cutting (terminating people) which can’t go on forever. Third of all, “The sense that now is the time to buy is starting to gain momentum as potential qualified purchasers are getting confirmation from news reports and the overall stock market that prices are at or near lows.” Cheerleaders. The stock markets are up 40-50% since March. It is more likely than that they pull back here before they go higher. Last of all, I agree with you that ” Stocks are calling the tune here, folks.” Look at the charts. Lately, seldom are the stock markets and the USD up or down together during the SAME trading session, so there is a “causation” between “dollar-equities”. When people put money to work by buying riskier equities the dollar goes down. So, what’s your point??

  3. Gatsby says:

    Criticism of this article aside (and I do agree with leftback with respect to ignoring the carry trade) the article does raise an interesting point: Can the government be inflating the equity market as a form of quantitive easing? Instead of injecting liquidity into banks who are stubbornly not lending out (we’ve seen consumer credit dropping in the last few months) is the Fed trying to inject liquidity directly into consumers by inflating thier net worth?

    Now I am not the tinfoil hat type by any means and I only make this point for the sake of discussion, but I still for the life of me can’t find an explanationd for why C, BAC, FRE,FNM and AIG have represented such an insane proportion of volume and who has been buying.

    Just thoughts…

  4. strousd says:

    Wake up, mr. equity strategist! It is obvious that all risk assets have been inversly correlated with the dollar. It totally makes sense that the carry trade is in play again, when it only costs 25 basis points to sell the dollar to finance purchases of stocks, corp bonds, currencies, and commodities. If the US economy is strengthening, then why isn’t the dollar rallying? The answer is that the stock market rally has nothing to do with what’s going on in the economy, it is driven by the carry trade and the flow of excess liquidity into financial assets instead of real assets. If the dollar rallies significantly, the stock market will take a hit.