Dollar up and stocks down--don't expect that to continue

10/28/2009 9:28 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

I can't tell you where stocks are headed in the short term but it does look like the days of the dollar rally are numbered.

Why do I think that? The central bank of India tells me so.

And if the recent relationship between the U.S. dollar and global equities holds, that means stocks are set to end their current losing streak in the not so distant future. (Recently stocks have gone up when the dollar ha gone down.)

The U.S. dollar has an interest rate problem--and it looks like it's getting worse.

The U.S. Federal Reserve has set its target for short-term interest rates near 0%. That makes sense if you're a central bank desperately trying to get your national economy going. Especially if three of your biggest problems are a depressed housing sector (low mortgage rates help), a money-losing banking sector (cheap money raises bank profit margins), and a reeling auto sector ( 0 down and 0% interest rate deals help sell cars.)

But a 0% interest rate doesn't help you currency much. Investors can earn more in bonds denominated in Australian dollars or Brazilian reals. Traders can borrow dollars in what's called the carry trade and then buy assets, again denominated in currencies other than the dollar,  that promise better returns.

The desire to sell dollars and hold other currencies gets even stronger when the interest rate differential between the U.S. and other countries is increasing. And that's exactly what's happening right now.

Earlier in October the central bank of Australia raised interest rates there. Australia was the first Group of 20 economy to raise rates.

And now India has followed suit. On October 27, the Reserve Bank oif India moved to take liquidity out of the banking system by raising the amount of reserves banks have to hold against loans and by increasing the percentage of deposits that commercial banks have to hold in government bonds. The moves are a likely precursor of an increase in interest rates in early 2010.

And these two moves are the beginning of a round of interest rate increases rather than the end. Norway raised its overnight interest rate by 0.25 percentage points to 1.5% the day after India's move. The central bank of Korea is also considering an interest rate increase.

Meanwhile the Federal Reserve has signalled that U.S. interest rates aren't likely to move higher before the second half of 2010 or early 2011.

Why the difference? Much of the world has emerged out of the global economic slowdown faster than the United States. While economists believe the United States could show a positive 3.2% growth rate for the third quarter in figures to be announced on October 29, thus ending a string of four quarters in which the U.S. economy contracted.

But that's rather tepid growth for a country emerging from a recession and it lags growth in many other economies. Government economists expect India, for example, to show 6.5% growth for the fiscal year that ends in March 2010. (Private economists think the government forecast is deliberately low.) Inflation, the usual companion to fast growth, is forecast to hit 6.5% by the end of March 2010. That's up from earlier predictions of 5%.

No wonder that India's central bank is looking at ways to damp inflation, including the traditional solution of raising interest rates.

The threat of higher rates and tighter money from a country's central ba bank inevitably causes a temporary sell off in the national stock market. The Mumbai stock market sold off after the Reserve Bank of India announced its moves.

But as investors saw last week when the Brazilian stock exchange quickly rebounded after selling off on news that the government would impose a 2% tax on overseas capital invested in Brazil, the downturn is likely to be short-lived.

You can't keep a good economy down.

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