The Best House In A Bad Neighborhood?

Daily State of the Markets 
Monday Morning – May 16, 2011

Good Monday morning and welcome back to the game. Until two weeks ago, the markets were fairly easy to understand. With Bernanke and Co. pledging to keep buying bonds until the end of June and also to maintain ZIRP (zero interest rate policy) for as long as there is any threat at all of deflation, traders knew exactly what to do. So, with the switch on the Risk Trade flipped to the “on” position, traders shorted the dollar and bought stocks and commodities.

However, with the deadline for QE2’s end looming and new problems cropping up across the pond, it looks like traders may suddenly have decided to flip the switch to on the risk trade to “off” and renew their love affair with the buck. And just in case you’ve missed it, the rally in the dollar has been a bad thing for stocks and commodities.

Why is the dollar rising, you ask? After all, aren’t there ongoing problems with our economy such as the renewed downturn in housing prices and the fact that job job growth is anemic? Isn’t the Fed going to keep rates low? Isn’t the U.S. consumer still nervous and drowning in debt? And isn’t all this talk about austerity and cutting spending in Washington going to be a drag on the economic growth going forward?

My answers to the above questions would be yes, yes, probably, and yes. However, with the problems in places like Greece growing again, suddenly the U.S. and its currency look like the best house in a bad neighborhood.

Let’s keep in mind that the dollar, as hated as it is in some circles, is still the world’s reserve currency. As such, when bad things happen, investors in the ever-shrinking global economy scurry to put their cash in the safest thing they can find – the U.S. dollar. Never mind the fact that the value of the dollar has been falling and was just recently at multi-year lows. The bottom line is that when the threat of a crisis begins to grow, the dollar is where investors put their money.

With the linkage between the Euro and the dollar so high at the present time and the direction of stocks and commodities tied to the movements in the dollar, it would appear that macro-oriented investors have a decision to make right now: Are you bullish on the dollar or not?

Lest we forget, the dollar-carry trade (where investors short the dollar and invest the proceeds from the sale elsewhere because they are confident the dollar will go lower and “risk assets” will go higher) has been all the rage for some time now. As a result, this has become a VERY crowded trade in hedgieland. Thus, if a fundamental reason for the dollar to rally should emerge, there could be some fireworks in the buck as the fast-money rushes to cover their shorts.

In addition, some analysts argue that the dollar is going to be heading higher not because of the wonderful growth prospects here in the U.S. (although GDP growth is expected to be in the 3.0% – 3.5% range this year) but because of the worsening situation in the PIGI’S and the question regarding the future of the Euro. At issue right now is the very real possibility that Greece may be working toward restructuring some of its debt, which, in English, means that they will default on the current bonds and issue new ones.

On this topic, the bears are quick to remind us that a downward spiral can quickly ensue when such an event occurs. Remember, when someone defaults on a loan, all debt of the issuer gets downgraded. This causes “forced selling” and fire sale prices. And with prices diving, more selling is required by banks holding loans… Does any of this sound vaguely familiar?

Finally, I want to apologize for sounding like Debbie Downer this morning. But with the stock market basically tied to the dollar and the dollar trading inversely to the Euro right now, we have to accept the fact that if the debt crisis begins to percolate from here, the greenback is going to move higher. The good news is that at some point, the linkage between the dollar, the Euro, and stocks/commodities will come to an end. But for now, this is the hand that is being dealt.

Turning to this morning… The arrest of IMF Managing Director Dominique Strauss-Kahn on sexual assault charges has dampened the mood a bit this morning as uncertainty over the impact of the bailout programs for the PIGI’S.

On the Economic front… The Empire Manufacturing Index (designed to indicate the state of the manufacturing sector in the New York region) for May was reported at 11.88, which was well below the consensus expectations for a reading of 20.0 and below the April’s reading of 21.7. In addition the Prices Paid component jumped to 69.89 from 57.69. However, Employment rose to 24.73 from 23.08 and 6-month Business Confidence increased to 52.69 from 47.44.

Thought for the day… Don’t forget, ego is the real enemy in this game…

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell…

• Major Foreign Markets:
  • Australia: -1.32%
  • Shanghai: -0.73%
  • Hong Kong: -1.36%
  • Japan: -0.94%
  • France: -1.31%
  • Germany: -1.25%
  • London: -0.84%
• Crude Oil Futures: -$1.09 to $98.57
• Gold: +$2.20 to $1495.80
• Dollar: higher against the Yen and pound, lower vs. Euro
• 10-Year Bond Yield: Currently trading at 3.178%
• Stocks Futures Ahead of Open in U.S. (relative to fair value): 
  • S&P 500: -5.27
  • Dow Jones Industrial Average: -37
  • NASDAQ Composite: -5.50

Wall Street Research Summary

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