the economy

A cautious optimism is the best way to describe my feelings on where the S&P is headed while the dollar is most likely to see some measure of decline, at least in the early going this week.

S&P

The market suffered a late-day sell off on Friday after rumors of a South Korean naval vessel being sunk as a result of a conflict with North Korea spread. The won also dropped against the dollar. However, “given the investigations by government ministries so far, it is the government’s judgment that the incident was not caused by North Korea, although the reason for the accident has not been determined yet,” a senior government official was quoted as saying by Yonhap news agency in South Korea.

Presidential Blue House spokeswoman Kim Eun-hye earlier said there had been no unusual movements by North Korea.

Purchases are expected to have increased by 0.3% and incomes likely rose 0.1% in Monday’s report from the Commerce Department. Sales have been increasing for the last 4 months while incomes are looking for a second monthly gain.

The Conference Board’s confidence index, scheduled for release on Tuesday, probably increased to 50 from 46 in February.

On Friday, economists are expecting to see a gain of 190,000 jobs in March, the biggest increase for 3 years.  Some of the boost is expected to come from the hiring of temporary government workers to conduct the 2010 Census and from better weather. The unemployment rate is expected to hold at 9.7% for a third straight time. Unemployment peaked at 10.1% last October.

From a technical viewpoint, price has appeared to have found support near the former resistance at around 1150 and the longer it holds above this level, the more confidant investors will feel.

The Dollar

We’ve been down this road before, but it appears as if traders are satisfied with the latest developments regarding the Greek debt situation. A plan announced at the conclusion of meetings in Brussels on Friday which will involve the use of a joint IMF-EU backstop, should one become necessary, led the euro to a 124 pip gain on the day.

What has become evident is that the Federal Reserve now seems far more likely to make a move on interest rates ahead the ECB, although when exactly that might happen still appears to be a ways off. Bernanke reiterated that the employment situation is still “very weak” during congressional testimony last week and reports showed that inflation continued to remain tame.

In fact, dis-inflation seems to be the rule of the day. Core CPI rose just 1.3% in the year to February and the trend appears to be slowing as well; the core measure rose just 0.8% annualized in the 6 months to February, less than half the 1.9% increase seen in the prior 6 month period. In the last 3 months, core has risen at an annual rate of just 0.1%.

However, current monetary policy was implemented under emergency conditions and the facts are that the situation has changed. Credit spreads are low and corporations have easy access to capital markets. Profits are expected to increase by 30% this year and the economy could see 3% growth. Quantitative easing (aka the printing of dollars), will officially end this month although the Fed has left the door open to additional measures, should they become needed.

Bottom line-the dollar is most likely to continue its strengthening trend as the year progresses, especially against the euro. In my opinion, $1.20 to the euro, and even below, is well within the realm of possibility under the current economic outlook.

Fed Chairman Bernanke’s little stock rally, which was initiated when he announced on 60 Minutes that the Fed was “electronically’ printing dollars, has apparently come to an end (at least for now). As a currency trader and market observer, you’ll want to know why and the reason has to do with the most famous currency pair you’ve never heard of. Ready? It’s called…

S&P/USD

That the dollar moves inversely to riskier assets like stocks (and commodities as well) isn’t a matter of some kind of mystical correlation that can somehow “break.” The key to knowing this is to understand what really is happening when stocks (or commodities) appreciate, which is easy to see once you accept the existence of S&P/USD.

Look at it this way; when stocks go up, what are they going up against? The dollar of course. The same for goes for commodities because those are priced in dollars all over the world. Well, if these riskier assets have gone up, isn’t it than also true to say the dollar has depreciated. Absolutely. So when the market is buying risk, the dollar will tend to fall as a matter of due course.

What’s really interesting is that in the rare instance (like now) when the Fed is actively trying to devalue the dollar (because the economy is faced was the more serious threat of deflation), the Fed can create a stock rally just as Bernanke intended to do by admitting to the electronic printing of dollars on national television. Why? Because if you are convinced the dollar is going to depreciate, doesn’t that also mean that anything you can buy with it is going to be more expensive? Of course. And the convinced you become that the prices of liquid assets (like stocks and commodities) are going to rise, the more inclined you will be to buy them.

So what’s really happening in the current environment is that the Fed, through its actions and comments on the dollar (and on deflation/inflation which is the same thing) is pushing the market for riskier asset classes up and down. Let’s look at some recent action.

Bernanke’s rally pretty much fizzled out in the middle of May, but it got a temporary boost (about 4%) in the week following the last meeting on June 24 when members removed the deflationary concerns which had appeared in the April 29^th statement. But then something interesting happened.

On June 30, San Francisco Federal Reserve Bank President Janet Yellen expressed some deep concerns about deflation. “I’ll put my cards on the table right away,” she said. “I think the predominant risk is that inflation will be too low, not too high, over the next several years.”

Now, remember what we said; if the market is convinced the Fed is depreciating (creating inflation), riskier assets are going to be bought because inflation means their prices are going to rise (at least nominally). No one wants to hold cash if the potential for inflation is on the horizon, because cash is guaranteed to lose value in an inflationary environment.

Conversely, if inflation really isn’t a threat and the possibility of deflation exists, there’s no reason whatsoever to buy riskier assets. Afterall, your cash is guaranteed to increase in value in a deflationary environment because prices are going down!

In fact, in a deflationary environment you make more money simply by being a “lender” (keeping for money in the bank or in Treasuries). A little arithmetic will show you how this works.

Your real (inflation adjusted) rate of interest is equal to the nominal rate (what the bank is paying you) minus the rate of inflation or R = N – i.

Let’s say inflation is 3% and your bank is paying you a nominal 4% on your deposit. Your real (R) interest rate is the Nominal (N) rate minus inflation or R = 4% – 3% which equals 1%. In real terms you’ve only earned 1% on the money you have in the bank

Now, let’s say there’s deflation (negative inflation) of -2% for the year and your bank is paying you a nominal rate of 3% on your deposit. What’s the real rate of interest you’ve earned?

R = N – I or R = 3 – (-2) = 5%. In real terms, you’ve earned 5% on your deposit!

Now, if I’m guaranteed to earn a risk-free return of say 5%, and I think prices are going down, why in the world would I buy a riskier asset? In the hope that someday its price might go up? Hope is a bad rational for making a trade.

So, Ms. Yellen, with her deflationary concerns, helped kill the rally. She wasn’t alone however; the Fed, with its expert manipulation of the media via the pundits seen all over Bloomberg, started so make plenty of deflationary noises around the middle of May.

As a trader, there are times when you can put this to very good use for longer term trends (which really is where the money is made). If the Fed does start talking about inflation and making noises like it might raise interest rates, do yourself a favor and sell the dollar as you buy riskier assets like stocks and commodities.  But if they continue to talk about the risks of deflation, there’s little reason to sell the dollar or to buy riskier assets. Buy the dollar at that point because it will be in demand.

BTW, Thursday’s weak market action off the surprisingly good unemployment numbers, along with the subsequent decline of S&P futures overnight, bodes very poorly for stocks and very good for the dollar. I can hardly think of a more bearish sign for stocks than the market failing to rally on good news. Afterall, it the market can’t rise when the news is good…