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The Sensex, dollar and gold tango

The Sensex, dollar and gold tango
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First Published: Thu, Dec 24 2009. 09 59 PM IST

Updated: Thu, Dec 24 2009. 09 59 PM IST
The markets are spotting a recent new trend: Stocks are going up in spite of the strength of the US dollar.
It’s well known that emerging markets are inversely correlated with the strength of the dollar, the logic being that a weak dollar provides the extra benefit of currency appreciation when US investors put their money in emerging market stocks. This is seen from the fact that the Bombay Stock Exchange’s Sensex index started to surge from March this year, at about the same time when the US dollar index started its long slide downwards. The most recent trend then is probably temporary, caused by thin holiday trading in forex markets.
Another interesting correlation is that between the dollar and gold. The price of gold, too, moves inversely to the dollar, but it’s not so cut and dried. Though the US dollar index had been falling since March, nothing much happened to the price of gold, which started going up sharply only from September. But the recent strengthening of the dollar did reverse the gold rally.
The imperfect correlation is only to be expected. A host of factors affect stock and gold prices and the dollar is just one of them. Nevertheless, it’s an important factor.
Also Read | Teeter-Totter Trend (Graphics)
The inverse relationship between the dollar and emerging markets held during the last boom, when the dollar weakened substantially. At the time, the massive US current account deficit was the main reason given for the decline of the dollar. At present, that deficit has come down to around 3% of US gross domestic product (GDP), well below the peak of 6.5% of GDP in the fourth quarter of 2005.
French bank Natixis has pointed out that this time the reason for dollar weakness is different, contending that it is due to capital outflows from the US on account of the very low interest rates. The report said: “If the US household savings rate remains higher, investment lower and the US trade deficit accordingly becomes smaller, this dollar weakness will be temporary and not permanent, as it will disappear when dollar interest rates rise again due to the future improvement in the economy.” Many believe that is why the dollar has started to firm up.
But with high fiscal deficits and with a natural tendency by the US government to inflate away its debts and export its way out of the downturn, the decline of the dollar should continue. BCA Research points out: “Fundamental conditions for a long-term dollar bottom are also not in place. Since the breakdown of Bretton Woods in the early 1970s and the move to floating exchange rates, there have only been two major bottoms in the dollar: the late 1970s and the early 1990s. These bottoms shared two common features: the dollar had fallen to deep undervalued levels and the US current account balance had improved markedly, moving to a small surplus position. Neither has occurred yet. Bottom line: Continued US policy reflation should see the trade weighted dollar index fall to fresh lows.”
And even if US interest rates start to rise, they have to rise by enough to discourage the dollar carry trade. That is likely to take time, which should support both emerging markets and gold.
Write to us at marktotmarket@livemint.com
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First Published: Thu, Dec 24 2009. 09 59 PM IST