Markets Drop When Dollar Pops

By Ilene

Just two weeks ago, the financial media was buzzing about the U.S. Dollar’s steep decline and surging prices in commodities and precious metals. Last week, the Dollar bounced, trading in a range from 74.4 to 75.8, over 4% higher than the lows visited earlier this month.

From a technical perspective, we wrote on April 10, 2011,
“The failure of the 76 level concerns us, but with Bernanke signaling his intention to end quantitative easing in June, we think the Dollar is ready to rebound, and we feel it is unlikely that the 72 level will fail to provide support.” Contributing to the Dollar’s strength, the CME Group Inc., the corporation that operates the COMEX and NYMEX commodity futures exchanges, has been raising margin requirements for silver and several energy products.

As Dian L. Chu of EconMatters noted in this post, “Increased margin requirement could trigger liquidation contagion as traders may need to sell their profitable positions in other commodities or equities to raise cash in order to meet the new limits.” Forcing traders to sell positions to cover margin requirements caused a “Dollar short squeeze” as described by Wall Street Examiner’s Lee Adler.  If the dollar rallies, it means the short squeeze is getting worse.

What prompted the CME Group to raise margin requirements? Considering that inflation has become a worldwide problem, it is not farfetched to speculate that the Federal Reserve told the CME group to take action to bring commodity prices down. as posited by Bill Schmick.

In theory, Bernanke’s signaling that the Fed will allow the second round of quantitative easing (QE2) to end in June, without disclosing plans for QE3, should counter the Dollar’s decline. Without the Fed buying Treasuries via the Primary Dealers (i.e., ibanks, such as Goldman Sachs and JP Morgan), prices of Treasuries are likely to fall and yields are likely to rise.

The Fed also released a relatively light Permanent Open Market Operations (POMO) schedule for next week. Apparently, the Fed is trying to forestall further price inflation in food and commodities, notwithstanding its ongoing denials regarding inflation.

We have been observing a strong inverse correlation between the Dollar and equities, summarized by our catchphrase: “When the Dollar pops, the markets drop.” The reason is uncertain, and this inverse relationship has not always been the case. Perhaps it is a function of how the Fed is influencing the markets, with its QE2 scheme of issuing money to the Primary Dealers to buy Treasuries; these Primary Dealers turn around and flip them back to the Fed.

Increased liquidity in the hands of the Primary Dealers has artificially supported Treasury prices, holding yields down and devaluing the Dollar. Dollars, losing value and earning no interest, naturally flow into commodities – as “speculation” – and equity markets (“risk on” trades).

Washington’s blog estimated that High Frequency Trading accounts for up to 70% of trading volume.  Are the opposite moves in the Dollar and equities largely due to HFT programs running algorithms that buy stocks when the Dollar drops and sell stocks when the dollar rises?

If this trading pattern persists, a stronger Dollar would be a bad omen for both equities and commodities. Peter Hickson, global commodities & basic materials strategist at UBS, recently told CNBC that
“Momentum is going to be down … if you look at the technicals, I think there’s probably another 10 or 15 per cent down over the next couple of months.” FT reported that Prices of key commodities are falling. Chinese demand for commodities is slowing, in some cases dramatically. While the nominal value of China’s imports is increasing, this reflects higher prices. Volume data show that Chinese imports of key commodities such as copper, aluminium, soybeans and iron ore have fallen over the last year.

The threat that the U.S. government will hit the debt ceiling of $14.3 trillion Dollars loomed over the markets last week. Secretary of the Treasury Timothy Geithner warned of the consequences of inaction in the face of a possible government shutdown.

Lee Adler commented
“The Fed’s custodial data on FCB [foreign central banks] holdings through Wednesday suggested that the foreign central banks took their foot off the gas pedal. They had it floored for the past 4 weeks. If this is the beginning of a reversal in their short term buying cycle, that would be bearish for both Treasuries and stocks(Original Excerpt from PSW’s Stock World Weekly, and edited by EconMatters)

About The Author – Ilene is the editor and affiliate director at Phil’s Stock World with a fascination with the markets.

The views and opinions expressed herein are the author’s own and do not necessarily reflect those of EconMatters.

EconMatters [Facebook Page [Post Alert [Kindle

Read more posts on EconMatters »