Watch the dollar if you want to know where stocks are headed

05/16/2011 3:50 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

I hate to sound like a broken record but the strength or weakness of the U.S. dollar remains the big driver in global stock and commodity prices.

When the dollar is up, commodity prices fall and the prices of commodity stocks follow. That pushes down share prices in economies with big commodity exposure, such as Brazil. And the strength of the dollar right now correlates very strongly with weakness in emerging markets too.

The question this week as it has been for the last few weeks is how long that strength in the dollar will last.

Those investors hoping for a quick recovery in the price of gold, silver and copper; in the price of oil; in commodity stocks, and in emerging market equities are likely to be disappointed this week. The odds are that the dollar will continue its recent strength.

From a long range point of view the strength of the dollar makes no sense. The huge U.S. budget deficit and the negative long-term implications of that for U.S. credit ratings argue that the dollar is looking at a long-term downward trend.

I think that’s true in the long term but long-term trends are always punctuated by short-term moves in the opposite direction. That’s where we are now with the dollar showing surprising short-term strength for two reasons.

First, the dollar is strong because the euro is weak. This past week the euro hit a six-week low against the U.S. dollar. Eurozone finance ministers meet this week and I can’t tell which financial markets fear more: that the meeting will produce a plan to restructure Greek debt (which would require bond holders to take a haircut) or that the meeting will produce no plan at all. But the uncertainty hasn’t been good for the euro. (The arrest of International Monetary Fund head Dominique Strauss-Kahn on charges that he sexually assaulted a maid in his New York hotel has done anything to lessen the uncertainty.)

Second, the bond market believes that U.S. interest rates are headed upwards. Soon. Not the short-term rates that the Federal Reserve controls. Those will probably stay low until December or longer. But long-term rates, over which the Fed has very little control, are headed higher now, the market believes, as a result of the June end of the Fed’s program of buying Treasuries. The theory is that with the Fed out of the market, other buyers will have to step up to pick up the slack and they will demand higher rates as the price for buying more Treasuries. That conviction got a boost at week’s end with a lackluster auction of Treasuries. 

So how long do these two factors keep the dollar climbing?

The European Monetary Union has shown a singular inability to take decisive action on the euro debt crisis, but papering over the problems for another six months is probably sufficient to end the euro’s immediate problems. I’d expect approval of a deal to bail out Portugal and some inconclusive action from the region’s finance ministers on Greece will give the euro a breather.

But I don’t think the relief from that will be sufficient alone to stem the dollar’s climb.

That will take some experience in where U.S. Treasuries yields are headed after the end of QE2. If interest rates don’t spike with the end of June, as I suspect because by that time the financial markets will have anticipated higher yields from the end of the Fed’s program of quantitative easing, then the dollar is likely to stabilize or go into reverse. If U.S. Treasury yields don’t start an upward march in July, then I think some of the impetus for buying dollars will go out of the market. That fall in enthusiasm for the dollar is likely to be buttressed by the spectacle of watching the U.S. Congress come up with some utterly inadequate (or worse) budget deal as part of extending the U.S. debt ceiling. (The only thing less appetizing than watching sausage being made is watching Congress make legislation. 

So if you want my best guess on a timeline for how long the dollar will stay strong and commodities, commodity stocks, and emerging financial markets will stay week, I’d say until the end of June or into early July.

Week by week, you can watch the dollar to see if my schedule is correct.

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