Does the Buck Have Some Giddy Up?

I don't know about you, but I find myself watching a split-screen of the dollar and the S&P 500 during much of the day lately. I know that I've mentioned the inverse linkage between the dollar and the stock market a time or twenty lately and there may be a great many that are growing tired of the topic. But the bottom line is that I'm of the mind that if the buck gets some giddy up here, those in the bull camp might be phoning Houston soon with a problem.

The naysayers on the subject will try to convince us that the linkage between the dollar and the so-called risk assets (stocks, commodities, and emerging markets) has been weakening lately. However, I remain steadfastly concerned about the potential for an unwanted and untimely unwind of the dollar carry-trade should the dollar find a way to rally much farther.

Please don't think me a worry-wart or a perma-bear as I am indeed a card-carrying member of the glass-is-at-least-half-full club. But at the same time, I spend the majority of my days attempting to identify the driving forces behind market movements. And I can say this; if the dollar continues to rally, more sell stops will be hit – which, in turn, means more dollar buying. Let’s remember that being short the dollar is a very, very crowded trade. So, when traders return to the game in January, the linkage between dollar buying and stock selling just might reappear – and not in a good way.

What could cause the dollar to rise, you ask? How about any and all issues involving a flight to safety such as sovereign debt or geopolitical issues? (Good thing we don't have any of those things happening right now, right?) How about the idea of the economy perking up a little; or maybe even a lot? How about an uptick in interest rates? (Don't look now, but the yield on the 10-year is up 0.48% so far this month.) What about something like the Bernanke confirmation going south? And then there’s my personal favorite, good old fashioned, momentum-based, trend following.

On that note, I came across some research today that certainly definitely got my attention. On Friday, the PowerShares US Dollar Index (NYSE: UUP) was halted and did not open for 45 minutes. Since it is an ETF based on a currency contract, I assumed the delay had something to do with it being a quad-witch expiration Friday. But, believe it or not, the real reason the UUP stopped trading is it essentially ran out of shares.

The buy orders at the open on Friday were so large that the fund reached its approved share amount. Now THAT'S what I call demand! So, it is little wonder that the UUP spiked higher at the open (see chart below). PowerShares must now wait for SEC approval to issue the additional 240 million shares it wants to sell.

And for those of you that think the interest in the dollar is just a blip, consider the fact that over $1.7 Billion has come into the UUP this month alone. (Take a peek at the volume on the chart of the UUP and you’ll see that there are 5 days where the ETF has traded more than 10 million shares a day.) While that number may not sound all that impressive in this day and age where it takes a trillion to get people’s attention, we should remember that the UUP only has a total of $3.2 Billion in value.

PowerShares US Dollar:

Thus, we need to recognize that $1.7 Billion of the $3.2 Billion in the fund has come in during the last 14 trading days. And this, dear readers, is what the term "institutional buying" is all about.

This data actually makes me want to think about either jumping on the buck bandwagon right now or buying the first pullback. This is in direct opposition to those thinking that the dollar's recent run to the upside has to stop soon. In short, as long as institutions continue to buy with this degree of veracity, it is difficult to see how the UUP would weaken to any great degree.

However, this is not to say that we think happy days are here again in the dollar for the foreseeable future. No, our estimation is that IF this rally in the greenback has legs, then there is a good chance that it may last a while – but only until the dollar carry-trade is unwound. After that, currency traders will likely reestablish short positions in response to the massive deficit that will need to be financed (and then refinanced on an ongoing basis).

So, where does this leave us? I for one will continue to watch the relationship between the greenback and the stock market. And while this little adventure may turn out to be a false alarm, there is the possibility that a buck with some giddy up could be a problem after Santa leaves town.

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