Fed Rate Cut Equals Dollar Drop

Top Line: Wednesday's stock market tried to hold up but in the last hour the Dow dropped about 100 points. We're looking for some more upside...going into the inauguration. There may be some down days between now and then but when we are getting to the highs of the market these down days will not show up much. That will be a clue...people will be bullish going into the inauguration.

Wednesday's defining characteristics were centered on the weakness in the dollar. The dollar got hammered and has now fallen about 10% in the past week. (Check it out on Bigcharts.com with the symbol DXY.) At the same time, gold has gone up which makes sense since these two are opposing forces. What doesn't make much sense is the long Treasury bond continuing its rocket job, up another 3% today. (TLT is a good proxy.)

The latest moves are in the wake of the Fed's decision to lower interest rates to virtually 0. Now there is a question as to whether the Fed can pump money faster than the deflationary forces can drain it. We think this latest argument on deflation is too late. The Update has mentioned deflation as a possible outcome of the housing bust but this Fed is not about to let this happen.

The Fed Chairman, Bernanke, has said that money can be dropped from helicopters if need be. Now the Fed is going to be buying all kinds of debt, flooding the system with dollars, thereby weakening the dollar. We don't think the dollar will stop going down until we get to the top of the market sometime in 2009.

Yes, we think dollar weakness is stock market bullish. The reason for our thinking is that the dollars now being used to flood the system need to find a home and we think that home will be the stock market and commodities. What just doesn't make sense is that the Treasury bonds would hold up in a weakening dollar environment.

Right now, the world sees the US as the leader in generating global growth by lowering rates. We're not sure we buy the argument that lower interest rates cause lower currency values because the yen is probably the strongest currency on the planet and interest rates in Japan are lower than they are here in the US. But, the argument goes that the Europeans need to lower rates to match the expansionary policy of the Fed and that will cause the Euro to come back in down against the dollar. Again, we don't really have to buy the arguments, we just need to stay ahead of the moves, if possible.

The simple truth is that the Fed and the Treasury and the Government have now pulled out all the stops to try to generate growth. We have avoided saying that they are trying to hold up house prices because that is a tough job, ok an impossible job for now. What low interest rates do is encourage people to pursue riskier assets to generate more yield. This means all types of risky assets including mortgages and high yield bonds and all kinds of assets that are currently trading at lows not seen in decades.

What about house prices? The Fed is hoping to push mortgage rates down to levels that "force" people to consider buying houses. What rate would make you buy a house? There has to be some pent up demand for houses. The problem is that there is still too much inventory that needs to be sold and not enough mortgage underwriters willing to loan money unless there is a good risk coming to borrow.

Housekeeping: Thursday evening will be our last regular post of the year. We plan to lay out our current near term strategy and which direction the markets we follow are going. There may be further posts if unusual things happen over the next two weeks but we don't plan to go back to a regular schedule until Sunday, January 4th.