Analysis from AdvisorAnalyst.com

Outlook 2010: As Confusing as the Dollar and Stocks Rallying Together

During the last several weeks, I have discussed the U.S. dollar and yen carry trades, in Carry Trades Make and Break Markets, and Does the Dollar Rally Threaten the Loonie and Commodities? I believe the subject of carry trading will be centre stage as we get further into 2010.

The outlook for 2010 is confusing at best, not that it has ever been clearer in any other year. Some call for an outburst of inflation this coming year, while others forecast deflation. Stocks and the dollar are now rallying in tandem. All the various moving parts of the bond, equity, commodity, and currency markets are not behaving as conventional wisdom would dictate. So what makes sense?

Here are a variety of viewpoints to contemplate.

Despite the reversal of the inverse relationship of the dollar to stocks, that defined the March-to-November rally, Barton Biggs, of Traxis Partners, told Bloomberg yesterday that, "History would suggest that after such a severe economic shock like we've just had that the odds are that we're going to have a pretty good burst of growth in 2010, 2011," Biggs said. "I don't see any reason why we can't have a further rally in the dollar and a further rally in stocks. And my guess is that the next move in both could be on the order of 10 per cent."

Marc Faber, of the Gloom Boom Doom Report echoes Biggs, saying, "Stocks may rise as Federal Reserve Chairman Ben S. Bernanke is forced to inject more liquidity into the financial system, spurring inflation that prompts investors to shift assets to equities from Treasuries and cash." Faber presciently advised investors to buy stocks on March 9, 2009, when the S&P was at a 12-year low.

Richard Russell, of The Dow Theory Letters, is bullish gold. He is doubtful of the Fed's ability to rollover the massive $7-trillion (U.S.), and commercial real estate's $750-billion in mortgages. Interest rates will go higher. He calls it an inflationary depression, and as the dollar is called into question, panic (buying) will ensue in gold, as it is the only real money there is.

Mohamed El-Erian, co-Chief Executive, PIMCO, says, "Many of the bulls don't appreciate just how much the government props still under the economy are masking its weakness. Instead of focusing on the fundamentals today," he says, "they're looking to the past, expecting a quick economic rebound because that's what's happened before."

"We're trained to think the "farther you fall, the higher you'll bounce back," El-Erian says. "We're hostage to the V."

In his annual top 20 surprises for 2010, Doug Kass, of Seabreeze Partners, says that, "Owing to draconian cost cuts," first quarter earnings will surprise in "glaring" fashion to the upside, but despite upward revisions, the "U.S. equity market fails to respond positively and the S&P 500 remains tightly range-bound (between 1,050 and 1,150) into spring 2010."

Kass also says housing and jobs will fail to revive, the dollar explodes higher, and gold falls to $900 per ounce.

Given our sense of markets these days, I am leaning in agreement with Biggs, Faber, and to a greater degree, appreciate Kass' reasonable approach to predictions/outlook for 2010, as I believe that the period will be marked the shifting tides of the carry trade, which will likely see the yen replace the U.S. dollar as primary funding currency in global trading.

According to Bloomberg, "The (2009) rally in stocks was accompanied by a 17 per cent retreat in the Dollar Index between March 5 and Nov. 25, the biggest slump since 1986. The measure tracks the currency's performance against the euro, yen, pound, Canadian dollar, Swedish krona and Swiss franc."

That is, in particular, why I agree with Kass, that the U.S. dollar will continue to rally, perhaps even explosively, and in the near term, gold may fall back to $900, all this as speculators cover their squeezed short positions in the dollar, and extend their short positions in the weakening yen as primary funding currency. Owing to the carry trade 'rollover,' markets could be volatile and range-bound well into 2010.

On the Canadian front, the shift in the carry trade may mean a return to volatility, though with strong yen-carry-trade support, commodity complex and related stocks could go modestly higher. Disenchantment with the U.S. dollar by foreigners, continues to mean that the loonie, which has recently garnered interest from China and Russia, could continue to remain stable at current levels or rise further.