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Fed impotence will compound dollar rally and market crash

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dollar_bill_origami_bullThe classic response by the Federal Reserve to a big downshift in the stock market is to cut interest rates, and thereby increase the attractiveness of investing in equities and reduce the cost of interest payments to companies. This will also devalue the dollar slightly, helping exports, and thus relieve the impact of falling equity prices on the dollar as a safe haven.

What happens then when the Fed can not cut interest rates? With interest rates close to zero options for the Fed are more limited now. Quantitative easing, or money printing, is an alternative to take real interest rates below zero but it is untested and the markets dislike uncertainty.

Exaggerated market swings

With the Fed so boxed in by ultra low interest rates then the logical outcome of a market correction would be a dollar rally of above average proportions, simply because the Fed can not cut rates. That would make US goods more expensive overseas and increase the trade deficit while reducing export profits.

At the same time a strong dollar would force commodity prices down and hit the profits of commodity producers. This would put further down pressure on stock prices.

Indeed, as Marc Faber has observed recently a weak dollar has been associated with relatively high stock market prices (particularly for such a weak economy) and a strong dollar would mean a much lower stock market.

Could the weakness of the dollar be topping out, and a weakening of stock markets be upon us? In the short term at least that could be the process that is about to emerge. Last week the dollar rallied and global stock markets fell.

Crucifying dollar bears

This would be a big surprise to dollar bears who point to record government spending and money printing as extremely negative for the US dollar. And that might well still prove to be the case in the long-run if the banks one day decide to put that money back to work rather than reinvesting it in treasury bonds.

However, in the short term the Fed is boxed in by an inability to cut interest rates, and that should exaggerate any stock market fall and the consequent rally in the US dollar and bonds. This greater volatility of financial markets will be a direct consequence of government intervention in interest rates, and highly destructive to the wealth of those who now feel safe in stocks and wary of the dollar.

After this mad swing in markets some sort of a contrary reaction should follow, and then dollar bears should have their day. Anybody who thought the financial crisis was over is about to get a nasty shock.

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Written by Peter Cooper

November 1, 2009 at 4:05 pm

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