At any rate, let's take a look at how things are shaping up - the title of this post really does say it all. Ever since the beginning of September, it has been all about the US dollar, and specifically, how the world perceives the Fed's actions related to the dollar.
Below is a chart of the US dollar index. As you can see, the USD has taken quite a trouncing since June/July.
And in this chart below, you will see the performance of the Euro vs the US dollar (EUR/USD - the red and green candlesticks), the Australia Dollar vs. the USD (AUD/USD - blue line), and the S&P 500 (green line).
Both of these charts are clickable by the way, and with the comparison chart directly above, I'd suggest right clicking and selecting open the picture in a separate browser window so you can more easily follow along with the coming commentary. What I want to point out here is the percentage change in the currency pairs vs. the percentage change in the S&P 500 over the same time period. As you will see where I have drawn in the parallel black lines, both the Euro and the Aussie dollar have appreciated roughly 10.8% against the US dollar since the end of Auguest. Now note the parallel red lines that bracket the performance of the S&P 500 during the same time period....also a 10.8% increase.
Before going any further, for those who aren't aware, the Forex (Foreign Exchange) market is the largest market in the world, facilitating currency trades 24 hours/day, five days/week. On any given day, the dollar value of executed trades in the Forex market is in the Trillions - think about it - this is where the world's banks not to mention the world's central banks (like the US Fed, the Bank of Japan, the European Central Bank, etc.), all come to play. In contrast the U.S. equities markets (DOW, NASDAQ, S&P) are only open from 9:30 AM - 4:00 PM EST, Monday - Friday, and only see trading activity in the low Billions. I make mention of this just to preempt anyone who might mistakenly be thinking that the direction and velocity of stocks has been driving the direction and velocity of these currencies. No chance. What happens in Forex will typically always manifest itself in the stock and commodities market. Apologies if this is too basic for some of you more advanced readers out there, but my main audience is family and friends, many of whom aren't active traders or investors.
Getting back on point - we've seen a huge run-up in the value of the Euro and Aussie in the past two months, which of course translates as a corresponding devaluation of the USD. Now why has the occured? One reason is because the Fed recommenced POMO activities at this time. For those who don't understand what POMO is, in a nutshell, the Fed has been monetizing debt by printing money to purchase US Treasuries....to the tune of Billions, and in some cases tens of Billions of dollars per week, every week since the end of August. In the most basic of economic terms, the more dollars that are printed, the lower the value of any existing dollars in the system. As a result, we have seen the dollar lose value against almost every currency in the world during the last several months, and the primary dealers (Goldman Sachs, JP Morgan, Morgan Stanley, etc) have taken this Fed money and used it to ramp the stock market....I won't go into it in much more detail now, but I've written more on POMO and the impact here, here and here for those who are interested in reading more.
The second, and arguably more important reason behind the huge devaluation in the dollar we've seen recently, is another topic that I've posted on a number of times in the past - QE2, or Quantitative Easing, round 2. All through September and October, we have been hearing from Bernanke and various other senior Fed officials that come November, the Fed will need to take a more active roll in jump starting the economy. By this, they are specifically referring to more QE, which is nothing more than what the Fed has been doing in their recent POMO activities...just on steroids. POMO has been limited to the Fed buying Treasuries, but QE would encompass Mortgage Backed Securites and other toxic assets that the big banks and bank holding companies still have on their balance sheets....and while no one knows yet for sure, the word on the street is that QE will be in the range of $100 Billion per month. Just to clarify - that means the Fed will be printing 100 Billion new dollars every month to monetize more debt, which is 5 -10 times more than the recent POMO's, so is it really any wonder why the USD has been getting crushed lately?
Now here is the interesting part about this whole dollar down, stock-market up action that we have seen lately. If this has all been predicated on a November 3rd FOMC announcement for QE2 in the amount of $100 Billion per month....what will be the market's reaction when the official announcement is actually made? Of course, that depends on what the Fed says, so let's break it out into three simple scenarios.
Scenario 1 - The Fed announces QE2 at $100 Billion/month. I think the markets will tank in perhaps one of the most famous "buy the rumor, sell the news" events of the past decade. Afterall, this anticipation of QE2 is the main reason why the dollar is down and the stock market is up over 10% in the past 60 days (in other words, it's already priced in), so once the "rumor" has been made official, what's left to cheer about? To be clear, I think this would be a short term sell-off, as once the Fed starts actively buying up $100 Billion/month, the markets will begin another ramp job, but the sell-off will likely be moderately severe at the outset.
Scenario 2 - The Fed announces QE2 at something less than $100 Billion/month: A very similar reaction as described in scenario 1 above, but likely a sharper and longer sell-off before a bottom is formed and the ramp job begins.
Scenario 3 - The Fed announces QE2 at something higher than $100 Billion/month: Equities will likely rally and not look back....S&P 1,300 by the end of the year.
But don't forget - the stock market will follow the Forex market, and the above scenarios are based on everything else in Forexland remaining somewhat status quo. If we see another big blow-up in Europe, similar to what we saw happen in April/May with Greece, all bets are off. Though the USD has been getting crushed due to incessant printing by the Fed, it is still the world's reserve currency and traditional flight to safety when other currencies are in crisis. As one friend of mine so appropriately stated, "The USD, relative to all other world currencies, is like the cleanest pair of dirty underwear in the clothes hamper!" Translation - as bad as the dollar is, if one or more of the other major currencies goes into crisis mode, the USD will rise as a result, and stocks will likely go down significantly.
Something else to keep in mind - the Europeans, especially the Germans and the French, are not happy with a $1.40 USD/EUR exchange rate. Just like a weak dollar is supposedly good for U.S. exports, so too is a weak Euro good for European exports. Big exporters like Germany will suffer if their currency continues to strengthen against the dollar, so don't be surprised if Angela Merkel starts getting vocal, putting pressure on the ECB (European Central Bank) to devalue the Euro by actively buying the USD...but that is getting into another topic entirely. Perhaps more on that over the weekend.
In the mean time, keep an eye on the dollar while we wait for the big FOMC announcement on November 3. Lately I've been doing much more Forex trading than in stocks, for reasons previoulsy posted, but I will likley have a play or two to post involving far out of the money equity options as we get closer to the big day.
Good luck trading!
Thanks for stepping through that, SMT!
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