The S&P 500 index peaked at 1,363 on April 29, and has been on a slow drip downwards since then. As at last Friday, the index closed at 1,333. If you were to plot a chart of the S&P 500 against the US dollar index (the DXY) over the same time period you will observe a strong inverse relationship between the movement in the US dollar and the movement in the benchmark US stock index. In fact, go back a full year or better still five years and you will see a clear inverse correlation between the two indices. A rise in the dollar has resulted in a fall in the stock market and a fall in the dollar saw the market rebound. A couple weeks ago, you would have noted my commentary on silver and commodities in general. The price of silver fell off sharply and this move contributed to weakness across most of the major commodities. In the end, it all comes back to the performance of the US dollar. Over the past five years, the US dollar index, which measures the US dollar against a basket of global currencies has peaked in the 85 to 88 range and floored in the 72 to 75 range. At the end of 2006, when the world was a very happy-go-lucky place and ignorance of impending troubles was bliss, the US dollar was trading at around 87. By the time Bear Sterns went under, it had fallen to a low of 71, the lowest reading in the five-year period.
As the global crisis accelerated, the markets sought the safe haven of US treasuries, which meant demand for the US dollar as investors swapped out of other currencies and asset classes. Coincident with a stock market bottom of 666 on the S&P 500 in March 2009 came the US dollar index peak of 89. As investors gradually started taking on more risk, they sold off US treasury assets, reducing the demand for dollars and bought into other asset classes and currencies. The dollar then began to work its way down. The floor came in November 2009 at around the 74 region and the rebound in the dollar started when the default events in Dubai began to unfold. This event was not sufficient to roil the stock markets so for a time the dollar and the US stock market were on a rally. By April of 2010, Greece came front and center on the radar screen and soon you had the PIGS of Europe, representing Portugal, Ireland, Greece and Spain. Once again risk was coming off the table and as investors sought the safe haven of the US dollar the dollar index rallied and the stock market fell. In April to May 2010, the dollar index was back at 88 and the S&P peaked from its March 2009 rally. Up to this point, the story revolved around the US trade and current account deficits and its loose monetary and fiscal policies that effectively implied a weak US dollar policy, even if the public and official utterances suggested that the opposite policy was in effect.
Euro weakness
The events in Europe created another dimension in that for the first time the very viability of the most palatable alternative to the US dollar, the euro, was being called into question. Leading up to April 2010, while the US was busy bailing out banks, printing money and pumping stimulus, Europe was maintaining a level of monetary discipline, which kept the euro strong. However, the implicit global policy in the era post the financial is one of "beggar thy neighbour," so the weak dollar measures effectively meant that the US recession was exported to Europe as US manufacturing and exports would be boosted by the weaker dollar with the opposite effect occurring in Europe. As Europe began to organise the bailout of first Greece, then Ireland and Portugal, some measure of confidence was restored to the euro, but this was only sufficient to stop the slide in the euro. Further into the summer months of June, July and August of 2010, the US economy began to experience a "soft patch" and there were questions as to whether the earlier "green shoots" of recovery would hold.
The debate over inflation moved to a fear of deflation which prompted the chairman of the US Federal Reserve to announcing further quantitative easing programs, firstly what was known as QE lite and then QE 2. These were the events that worked against the dollar, so that even if the euro was not on sure footing in absolute terms relative to the dollar, it was still able to rally. These QE programmes have been characterised as "money printing," which effectively increases the liquidity in the financial system. The increased liquidity saw money flow into real assets such as stocks and commodities sparking a rally in both asset classes. The S&P 500 was able to push up to levels last seen before the collapse of Lehman Brothers. Gold went past US$1,500 an ounce, silver touched on US$50 an ounce and crude oil was back over US$100 a barrel.
Dollar rebound
The US dollar index bottomed out at 72 on April 28, and soon after the S&P 500 index peaked. Investors will look for many signals to assist in reading the market action and the performance of the US dollar is a key indicator to assist in determining where the market is heading. Right at the April 28 floor of the dollar index, the problems in Greece began to rear its head again. This was discussed last week, but rather than getting better, the problems in Europe seem to be intensifying a bit. Elections in Spain are on and there is growing unease reflected in the performance of Spanish bonds, last week S&P downgraded the second largest bank in France one rating point due to exposure to Greek debt and the same S&P on the weekend put Italy on a negative watch. All of this could push the euro below 1.40 to the US dollar furthering the dollar rally. In terms of the US stock market as the dollar started its rebound, commodity related stocks began to sell off. These were oil and gas related companies, miners and those involved in resources. The next leg of the sell off, seen mostly last week involved companies that obtained significant revenues from exports. This was reflected in the weak performance of the technology sector during the early part of last week.
So far the money flow is rotating into more defensive stocks, with healthcare being the leader of that pack. However, the news out of retail have not been all that positive and there have also been some weak economic data coming out last week. An important reality of the past three years has been the degree of correlation experienced across markets. While the US dollar is often the spark, appreciate that a falling dollar has often sparked a fall in bonds, a rise in stocks and a rise in commodities and a reversal has seen just the opposite. Very often investors are left with no place to hide. We are now coming to an interesting point. US banks have up to now been able to borrow from the US Fed at near zero and invest in longer dated US treasuries in the process making a spread on the rate differential. The Fed through QE2 was also in the market for treasuries giving the banks an automatic buyer. Almost risk free money that then facilitated trades in riskier assets (stocks and commodities) pushing asset prices higher.
That dynamic is now coming to an end with the lapse of the QE2 programme in June. Where will the substitute come from? Will a substitute be necessary? How will the US treasury market fare? Will interest rates start to rise? The stronger US dollar is at this time reflecting the growing uncertainty in the market as risk is being taken off the table and into cash. If you want to stay on top of the market dynamics, then my advice is to follow the gyrations of the US dollar and understanding the drivers of any move whether it be up or down. Overall, while the US dollar may be trading in a range between 88 and 72 against other world currencies, for the past 10 years, it has been falling relative to real assets like gold and this is why I expect the commodities trade to remain on track over the long-term.
Ian Narine is a broker registered with the Securities and Exchange Commission