Dollar, Stocks Are Stuck in a Safe-Haven Hell

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Nick Godt's Market Medics

Aug. 11, 2010, 6:20 p.m. EDT · Recommend (4) · Post:

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By Nick Godt, MarketWatch

NEW YORK (MarketWatch) -- As Greece showed earlier this year, not being able to let your currency slide when you need it to can spell big trouble.

And while it might be for very different reasons, the U.S. might now be facing a similar problem with the dollar.

The competitiveness of Greek exports and assets, along with that of other southern European nations, suffered majorly last year as the euro jumped 20% from about $1.25 in March 2009 to a high above $1.50 in early December.

The euro's jump wasn't based on fantastic economic fundamentals: It was mostly a factor of a sliding dollar, which gave back the massive safe-haven flows it received as the financial crisis hit in 2008.

And the dollar continued to weaken through 2009 as the Federal Reserve, unable to further cut its key interest rate, unleashed creative measures to boost the economy by massively buying Treasurys and other assets, the so-called quantitative easing measures.

It's good to bear in mind that the dollar slumped last year as U.S. stocks, as measured by the S&P 500 index /quotes/comstock/21z!i1:in\x (SPX 1,089, -31.59, -2.82%) , rallied nearly 70% as the economy started to recover thanks to both the government's and the Fed's stimulus.

During that period, the dollar index /quotes/comstock/11j!i:dxy0 (DXY 82.43, +0.14, +0.17%) , which measures the U.S. unit against a basket of six major currencies, slumped nearly 16%. The risk-on, risk-off trade took advantage of cheap dollars (and yens) to borrow and invest into the global economic recovery theme. The weak dollar also helped boost U.S. exports.

Markets around the world are seeing sharp moves, with stocks plunging, the yen soaring and Treasurys rallying, amid fears that policymakers are running out of options to revive a slowing global economy . The technology sector is being hit hard again as fears about weak growth spark a bearish outlook for big tech companies,though Cisco is expected to report solid earnings after the bell. Paul Vigna, Madeleine Lim and George Stahl discuss

Not coincidentally, things started to shift around as the euro's strength became a bigger and bigger problem for Europe's attempt to recover.

For BNP Paribas currency strategist Sebastien Galy, the euro back at $1.50 late last year is what helped precipitate the European sovereign debt crisis early this year.

As the European crisis led the single currency to slide more than 20% all the way down to $1.18 in June this year, the dollar received another massive jolt of safe haven demand, and the dollar index gained about 17%.

Since June until recently, as panic over Europe's financial health subsided, the euro bounced back and the dollar once again weakened.

Could this be a repeat of the conditions that led stocks to rally last year? Not a chance, because this time, dollar weakness came just as the positive impact of U.S. fiscal spending that was too small to begin with in 2009 began to fade markedly.

And, as seen on Wednesday, the Fed doesn't seem convinced yet that the situation is so bad that it needs another massive round of quantitative easing. Read more on the Fed's move.

With the badly-timed manic drive to cut government spending in Europe and America, an easier Fed and a weaker dollar have become among the last hopes to avoid another global slump.

But as stocks stumbled on Wednesday, with the Dow Jones Industrial Average /quotes/comstock/10w!i:dji/delayed (DJIA 10,379, -265.42, -2.49%) sliding 225 points recently, the dollar was again carrying its safe-haven mantle, rallying nearly 2%.

According to BNP Paribas, Europe is also already showing signs of slowing down at the same time as China's effort to curb its growth appear to be working. With the risk trade in control of global financial flows, all these conditions should favor further gains in the dollar.

On the face of it, a stronger buck could be seen as helping cheapen the price of imports. But given global slumping conditions, it's likely to further fuel the threat of deflation, a condition that makes people less willing to borrow and spend, increases debt burdens, and pressures wages, prices and profits.

The likelihood of deflation in the U.S. and Europe has become a reality that's even now accepted by the conservative think-tank the American Enterprise Institute.

And As John Makin, who writes the economic outlook for AEI, wrote in July, "the underlying hope or expectation that easier money, a weaker currency, and higher exports can somehow compensate for the negative impact on growth from rapid, global fiscal consolidation cannot be realized everywhere at once."

"No wonder no country wants a strong currency anymore," Makin wrote.

Unfortunately, as has been shown repeatedly over the past several years, if conditions worsen in Europe and elsewhere, as they seem poised to do, the dollar will likely continue to see safe-haven flows.

The only way for it to drop, and for the economy and stocks to receive another boost, would be for another massive round of government intervention.

But with the government paralyzed by fiscal-austerity ideology, pressure is building on the Fed to really step up to the plate.

Nick Godt is MarketWatch's markets editor, based in New York.

Some wonder if the search giant is growing too quickly for its own long-term health, posits Jon Friedman.

12:09 p.m. Aug. 11, 2010 | Comments: 10

Were I to choose the most Idiotic article of the year, this is the one that would take first place. In reality, when the dollar was briefly "strong", back in 2008, and early 2009, our trade deficit plunged. That is because a strong dollar tempers America's throw-away buying habits. It teaches lessons in austerity that are critical if we are ever to get out of this rut and enter..."

- TTolstoy | 2:02 p.m. Aug. 11, 2010

"Europe's benchmark stock indexes trade in narrow range following Wednesday's rout http://on.mktw.net/dBBCbp" 2:16 a.m. EDT, Aug. 12, 2010 from MarketWatch

"Hong Kong shares fall, with property and resources wilting; Hang Seng Index down 1.4% http://on.mktw.net/bi6duO" 9:06 p.m. EDT, Aug. 11, 2010 from MarketWatch

"Japanese exporters help push market down sharply; Nikkei Average down 1.7% http://on.mktw.net/aczJkX" 7:10 p.m. EDT, Aug. 11, 2010 from MarketWatch

"Slide show: Beer on the wall http://bit.ly/aekxYK" 5:21 p.m. EDT, Aug. 11, 2010 from MarketWatch

"Price war threatens cereal makers' profits http://bit.ly/aze4ql" 4:19 p.m. EDT, Aug. 11, 2010 from MarketWatch

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