A Strong Dollar And A Strong Stock Market Is In The US Government’s Best Interest

Let’s think rationally about the US government and their main task at hand. If we can think like the government, then perhaps we can gain some insights into what to expect in the economy. Here’s what I view as their major tasks to accomplish in the near term:

1. Sell Government Debt.
2. Convince Rating Agencies that USA is AAA.
3. Pump up the US Stock Markets
4. Keep Interest Rates Reasonably low to support the banking system.

Let’s look at “Selling Government Debt”. In order to sell the debt, it needs to offer that debt at an attractive interest rate. The 30 year debt is now offered at around 4.5%, which is far more attractive than 2.5% back on 3/6/09 (market bottom).

How did the US government accomplish this feat?

They pumped up the US markets by providing capital to the banks and changing the rules to the game by making banks profitable (changes via FASB). This lift to the financials along with all the discussion about the economy bottoming/green shoots convinced people to sell bonds and move some money back into equities. The banks were then able to raise more capital.

The increase in government bond rates has opened the door for new purchases of treasuries by foreign central banks. The US dollar has also moved down to relatively low levels. It is in the middle of its 5 year range and it’s towards the lows of the range it has been in since 1999. This is what a bond buyer of treasuries would like to see.

If the US dollar was peaking out or making new highs, then buyers might be concerned about falling yields and weakness in the dollar. Given how low the dollar is today, buyers should look favorably on making new treasury purchases. The US government will ultimately support the US dollar by raising rates at some point. They will not do this until they have sold all the debt or a major portion of it. When the US government announce that they will start to raise rates, they will also most likely start to unload some of their own holdings as well.

When the US announce that they will begin raising rates, there will be an explosion in the US Dollar. As the US raises rates, it will signal to the rest of the world that we are cutting back on credit and this will have a bullish effect on the bond market and the US dollar. We might start to see some hints of this shortly, if the sell-off in the US Dollar really starts to pick up steam.

The raising of interest rates will support the AAA thesis. It will attract funds into the USA for investment. The bond rally will help to maintain lower rates, in support of the banking system. If the financials pick up more strength, then the broader stock indices will also do the same.

This past week saw a bit of a mini panic in the dollar. Everyone is long gold and short the US dollar. Whenever a trade gets that crowded, I start to look at the other sides of that trade. Why fight the government? A strong dollar and a strong stock market is in their best interest. I think that we can have a strong stock market, provided that interest rates are low and the dollar regains its footing. I still feel as though we may move lower, initially to re-test the lows made in March. The US economy is still the largest economy in the world. When the US economy is in the tank, so is everyone else. All this talk about decoupling usually takes place when the US dollar is faltering. I don’t buy into this logic. There’s just not enough demand in the rest of the world to support all the excess capacity that was created over the last five years.

It might also be time to start looking at the Ultrashort Gold Proshares ETF (GLL) which is the 3x short gold. It has moved down significantly over the last 10 days. If one believes that the US dollar failure will start to reverse itself, then perhaps this could be a trade.

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Comment by Forex-Aktuell

2009-11-22 21:04:32

Very nice analyse. I hope the dollar will recover slowly.

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