That’s what I noticed today as the dollar index fell 0.59% (that’s big in the currency world).

It’s a big deal because a falling dollar has usually led to gains in equities. But this time the market ended the day mixed. The Dow Jones was up 0.43% and the S&P climbed 0.23%. The Nasdaq stuck out like a sore thumb, falling 0.21%. It seems that the old dollar/stock market pattern isn’t holding up as well as it used to.

This indicates to me that the dollar carry trade is losing some of its luster. In the end, these ultra-low interest rates probably won’t last forever.  I expect the dollar carry trade to be replaced with the Yen carry trade (since Japan apparently doesn’t believe in higher interest rates). The new Bank of Japan governor has also shown a preference for a weaker currency. So moving forward, we should see a big correlation between the Yen and the US stock market.

As you can expect from a falling buck, gold was on the up and up, gaining $14 to close at $1,151 an ounce.

Honestly, though, I wouldn’t read too much into a falling dollar. The market has been data driven as of late. Investors are all looking for signs that the recession is truly over. And as long as this week’s reports show an improving economy, the market could head higher, taking the US dollar along for the ride.

The report I’m most interested in is the December Consumer Price Index report this Friday. This report measures inflation at the consumer level. If this report shows a big bump in consumer prices, the market could easily sell-off. That’s because higher inflation means the Fed is more likely to boost interest rates.

And higher interest rates signal an end to cheap money.

Will the CPI come in very high? I doubt it. Gas prices were close to flat in December. And at the same time, retailers were discounting everything. So I wouldn’t be shocked if CPI came in at or under consensus (0.0%-0.1% gain).

At this point I’m cautiously bullish, especially on the commodity complex.

Outcome #1 : Dramatic Fed tightening pushes the buck higher as carry traders sell off their assets and buy back the dollar. In this scenario, markets would plummet viciously.

Outcome #2: The Fed raises rates slower than the rest of the world and the carry trade continues. Eventually, higher interest rates  make the carry trade less profitable and the Japanese Yen, which also has near 0% interest rates, becomes the carry trade of choice. In this scenario, the market keeps moving higher.

What the Feds do depends on inflation expectations. If everyone anticipates higher inflation, the Feds will jack up interest rates quickly. But if  inflation isn’t a concern (the view at the moment) then interest rates won’t move up so quickly.

The economy is running on pointless tax credits and stimulus spending, nothing else. And the U-6 unemployment rate will likely hit 25% by the time this thing bottoms out. So I doubt the Feds will raise rates before the second half of 2010. And if the Feds do raise rates earlier, it just means that inflation expectations had gotten severely out of whack.

That’s why the dollar carry trade will soldier on and keep fueling this market until next year. Sure, we might see a few minor 5% – 10% sell-offs over the next few months. Hell, the Dow may never pass 11,000.  But I doubt we’ll ever see 6,000 on the Dow Jones ever again.

MARKET TREND OUTLOOK

The trend is still up, but the major indexes are all overbought. So we’ll probably see a 3%-5% sell-off.

Use any major sell-offs as entry points unless we see a lower-high, lower-low pattern forming.

http://www.bloomberg.com/apps/news?pid=20601087&sid=aQ7HBEgYCzUE

That’s a lot of disappearing cash…

Of course I wonder how they calculate “household wealth”.

Then I found this out…

Sheryl King (Merrill Lynch analyst) writes that household balance sheets shed almost $3 trillion in the third quarter, thanks in large part to a decline in stock prices. That loss, the largest 3-month drop on record, brings the total loss by U.S. households in 2008 to $10 trillion, or about 10 years worth of equity earnings.

So it looks like household wealth at least has stock portfolios and home values figured into the equation (although I question the wisdom of considering a mortgaged home a form of wealth).

Anytime household wealth begins dropping, it makes people feel poorer. This switch in moods can affect an entire population. And then it changes the mindset from “spend, spend, spend” to “save, save, save”. From that same report…

Persistent negative wealth effects from the slide in housing and equity prices should reinforce the uptrend in the personal savings rate, creating a highly disinflationary environment as job losses mount and unemployment rate rise toward 8-1/2% in the coming year. We estimate that the savings rate will rise to around 5% by 2010, on its way towards a more sustainable 6-7% at some point just beyond our forecast horizon. This is a daunting prospect for future US economic growth given that for every one percent increase in savings, consumer spending – that 70% of the GDP pie – is suppressed by a roughly equal amount.

So it seems that the velocity of money will slow in the coming YEARS. That could put a ceiling on how bad inflation could get (since saved money is money not spent. And money not spent does not contribute to price inflation).

And to think, we’re going to see even more losses from the commercial real estate bust, the emerging market bust, the municipality bust, the credit card debt bust, and the list goes on…

I just don’t see how a long-term rise in inflation could possibly happen in this environment. Perhaps in a few years, but it doesn’t seem like it could happen tomorrow, or next month, or even this year.

- CD