Will a Dollar Reversal Coincide With a Pause in the Reflation Trade?

While the stock market has rallied +57% since the March 9th low, the value of the U.S. dollar, measured against a basket of currencies of our largest trading partners, has dropped by almost -14%. This inverse correlation (statistically measured as -0.66, indicating a strong inverse relationship) isn’t something new; if one looks at the correlation between the market and the dollar it has been negative since the market top in October 2007 (measured as -0.49 since then). There are many theories as to why this is the case, such as the dollar’s reserve currency status in a time of crisis, the reflationary aspects of a weak currency, and the positive effects of a weak dollar on repatriation of earnings for multinational companies.

As the dollar has fallen, it has helped ignite a trade that is commonly referred to as the “reflation” trade. Reflation is the act of stimulating the economy via monetary and fiscal stimulus to expand output. Typically as the stimulus is applied, lower real interest rates and deficit spending combine to weaken the currency, which makes exports cheaper and in turn fuels growth. We consider a number of sectors and asset classes to be particularly sensitive to reflationary policy as well as a weak dollar, including certain US equity sectors (like materials, energy, and industrials), emerging markets stocks, commodities (such as oil, copper, gold, etc.), and other hard assets like property. If one looks at the performance of those assets since the March bottom in stocks (shown in the table below), it’s clear that reflation trades have outpaced the broad market. But beware, since even strong market trends are subject to periodic adjustments, and these reflation trades have reached a point where they seem vulnerable if the markets correct and the dollar bounces.

Our current view is that the cyclical bull market in stocks has not yet fully run its course. At the same time, some of the shorter-term technicals we monitor appear stretched, and a healthy correction would not be surprising. Should that occur, we won’t be surprised to see short term fireworks in the dollar and reflation trades.

The Reflation Trade Back On

As we end this week with a strong 7% plus gain in the S&P 500, it is clear that the reflation trade is back on. These are generally stocks characterized as benefiting from rising inflation, which would be welcomed by some at this point in time. The usual suspects in this group include commodities and commodity related stocks, and emerging markets. Metals and Mining and steel stocks soared 15% this week, and natural gas posted a strong 13% in four days to provide some examples. So why was there a stampede back into these positions?

One reason is simple – the dollar has fallen this week due to increased action at the Federal Reserve. In the four weeks prior, the Federal Reserve held steady on its Quantitative Easing program and they did not increase their balance sheet. Now, this week the Federal Reserve increased its balance sheet by $80 billion mostly through Mortgage Backed Security purchases. This caused a 1.5% drop in the dollar and due to negative correlations commodities and related stocks were bought.

Secondly, perhaps the rebound in the Chinese economy contributed to the renewed enthusiasm for emerging stocks. The growth for the second quarter came in at an annualized rate of 7.9% which is stunningly close to the hoped for growth rate of 8%. (Insert generic disbelief about China economic statistics) This was enough to allow Chinese economists to declare that the ‘downturn has been successfully reversed’ and they are ‘leading the turnaround in the global economy.'

I’m sure there are other reasons behind the surge as well, but one thing for sure is that it occurred. Now it is time to see for how long.