Let’s get real about dollar-equities causation

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

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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)