The Dollar Breaks Out

"Money can't buy you happiness but it does bring you a more pleasant form of misery." - Spike Milligan

This week the dollar (as measured against a basket of currencies, predominantly the Euro) broke out.  As you can clearly see from the chart below the strength in the dollar has been building for some time.  This is predominantly due to the considerable weakness in Europe rather than a show of strength in the United States however what are the implications of a stronger dollar on the world's largest economy?

Typically strength in a country's underlying economy results in a strengthening of their currency.  The attraction of foreign capital to that economy results in a stronger currency but the implications are far deeper.  A stronger currency means lower rates of inflation.  Think about it, as the dollar strengthens the price of imported goods, in dollar terms, falls.  On the commodity front, as most commodities are priced in dollars, the price to the rest of the world increases.  As this price increases the demand for these items falls, once again resulting in reduced inflation to the United States.

So does this dollar strength mean that the united States economy is strong?  Well in relation to the rest of the world we are doing quite well.  Our housing market seems to be bottoming, job growth while still anemic is growing, interest rates are low and should remain low for a long time to come particularly if the dollar remains strong, this low interest rate will start to feed into positive growth and if inflation remains tame things look kind of good!

So why is the market falling if things are looking up?  The market is forward looking and while things appear to be getting better I believe that it has run too far too fast.  In addition the problems of the rest of the world can easily come and bite us right where it hurts and this uncertainty will weigh on the market.  As it looks forward, uncertainty is not a good ingredient for positive market returns.

So as long as the dollar strengthens will the market go down?  In trading these types of correlations occur all the time and are reliable until they are not -  meaning that for the present time if the dollar strengthens the market will fall but at some point this correlation will be broken.  In other words, dollar strength does not necessarily mean that the market will fall, but it does right now.  In the past a strong dollar would normally point to a strong economy which would point to a strong market, but the problem is that the dollar is not strengthening due to a strong economy but due to weakness everywhere else.

The good news is that this strength is buying us a lot of time to repair our damage and insulate ourselves as much as possible from the impending crisis in Europe.  However, as the world economy is so tightly knit it will be impossible to protect ourselves completely from any fallout in Europe (just look at the JP Morgan mess) meaning that the risks in Europe will weigh on the market regardless.  So while it certainly appears that some of the underpinnings of a good economy are being put in place, if there is a hurricane from Europe our tent pegs will not hold down a half erected tent and it seems that it is only a matter of time before that storm hits our shores.