Better watch the value of the U.S. dollar

financial focus with fred hubler

Weekly Market Recap

Major fluctuations in the stock market tend to grab the headlines, but there's something else investors should keep their eye on, too - the value of the U.S. dollar.

As the worldwide financial system melted in late 2008/early 2009, investors fled to the perceived safety of the U.S. dollar and its value soared compared to a basket of other currencies, according to The Wall Street Journal. There seemed to be an inverse correlation between the dollar and the stock market; as the stock market went down, the dollar went up and vice versa.

Following the pattern, the dollar was very strong leading into the stock market's nadir in early March and as the market started its dramatic reversal, the dollar reversed, too. The so-called "risk trade" was on as investors dumped "safe" investments and moved into "risk" assets such as stocks and commodities. Massive liquidity and ultra-low interest rates also helped fuel the movement into riskier assets.

But, like a great book, the risk trade will end at some point. On December 4, the Labor Department reported a much stronger than expected employment report. This helped strengthen the dollar as investors began anticipating a quicker return to higher interest rates. Higher interest rates help make the dollar more attractive compared to other currencies, but may have a side effect of slowing economic growth. Concerns about debt problems in countries such as Greece, Spain, and Portugal are also supporting the recent rise in the dollar. Sticking to the script, the U.S. stock market rally has stalled over the past few weeks as the dollar appreciated.

Here's the tricky part. Historically, the dollar and the stock market did not always have an inverse correlation. It is possible to see the dollar and the stock market go up in unison. Correctly forecasting when the dollar and the stock market will break their recent inverse link would just be a lucky guess. Since we don't rely on luck to be a successful investor, we continue to monitor the value of the dollar and look for clues on what it might say about the future direction of the equity markets.

SPEAKING OF GUESSES, what do you think will be the average inflation rate over the next 10 years? Interestingly, there is a simple way to determine how bond investors would answer that question. All you have to do is look at the spread between yields on 10-year Treasury notes and 10-year Treasury Inflation Protected Securities (TIPS). TIPS are Treasury securities that adjust the principal twice a year to reflect inflation or deflation as measured by the Consumer Price Index (CPI). By comparing the yield difference between the two, you have the market's best estimate of inflation over the next 10 years.

As of last week, the spread was 2.3%, according to Bloomberg. That means investors expect inflation to average 2.3% over the next 10 years. This is the highest expected rate in 16 months. By contrast, during the height of the financial panic late last year, The Wall Street Journal reported that the spread was actually negative, which means investors were predicting 10 years of deflation!

The government may not be too concerned about inflation right now because it may help them dig out of the debt hole by paying back the debt in "cheaper" (i.e., inflated) dollars. However, too much inflation, like eggnog, would be painful and cause new problems.

Inflation is one of those indicators that has the potential to move markets and, fortunately, it is easy to track. We can track the expected inflation rate as described above. We can read the government CPI report each month. And, of course, we can go to the grocery store and see if prices for milk, eggs, and bread are rising or falling. Currently, inflation is under control, but the tail risk - either rampant inflation or deflation - is still possible.

Weekly Focus - Think About It

"Inflation is the one form of taxation that can be imposed without legislation." --Milton Friedman

If you would like more information please visit Opinions expressed are subject to change without notice and are not intended as investment advice or to predict future performance. Consult your financial professional before making any investment decision. You cannot invest directly in an index. Past performance does not guarantee future results. This information was prepared by PEAK. Frederick Hubler is a LPL Registered Principal and is President of Creative Capital Wealth Management Group, Your Financial Translator! Securities and Advisory Services offered through LPL Financial, member FINRA/SIPC.

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