Friday, November 24, 2006

Connecting the Currency Dots

With the vigorous economic expansion we've had over the last few years--earnings for the S&P 500 stocks have tripled since 2002--one would think that the U.S. dollar would be robust vs. other currencies. As the chart from the excellent DecisionPoint service makes clear, however, the dollar is weaker now than during the start of the equity bull market. It's a little hard to see in the chart above--my Weblog entry has a larger chart--but we've broken trendline support in the Dollar Index. Now, this AM, we see the dollar in freefall against the Euro and Sterling and stocks are down in pre-opening trade by about a half-percent.

Let's connect the dots. A large portion of the Democratic victory in Congress is attributable to the party's strength in the labor states of Ohio, Michigan, and Pennsylvania. Those candidates ran against globalization and won. The Democratic leadership has already worried Asian leaders, by going on record as favoring punitive tariffs against China if that country doesn't allow its currency to rise against the dollar. Which, of course, is another way of saying that Democrats want to reduce the value of the dollar vs. the yuan.

The Secretary of the Treasury and the Fed chief have formed a delegation to China to head off a confrontation between the upcoming Congress and that country. Meanwhile, we now hear that China is considering reducing its dollar reserves due to--surprise!!--dollar weakness. That has tanked, not only the dollar in this morning's trade, but equities as well.

The reality is that China has amassed foreign currency reserves to the tune of one trillion dollars. The message from China is that, if we push them too hard on their economic policies, they will push back by diversifying those reserves out of dollars and into Euros, Sterling, Yen, etc. That places Mssrs. Paulson and Bernanke between a Democratic rock and a Chinese hard place.

It also generates considerable dollar uncertainty, which has gold rising this morning and stocks falling. Figuring out the investment themes that will be winners and losers in a weak dollar scenario may prove crucial for traders going forward. At the moment, with weak housing precluding meaningful interest rate hikes and the perils posed by the potential clash between Congress and China, it is difficult to imagine a scenario that does not involve, at the very least, a managed drift of the dollar lower. Particularly when you consider the expansion of M3 money supply in the face of an inverted yield curve, as noted by Barry Ritholtz.

And at some point, global traders will question pouring their money into dollar-denominated assets that sport such currency uncertainty. Which is what we're seeing this morning.