Analysis: Stock market gains, growth smile on U.S. dollar

The stars are aligning for U.S. dollar bulls.

For more than a decade, good times in such markets as stocks and real estate were bad news for the greenback. Investors tended to use the U.S. dollar only as a life jacket when storms raged in risky markets.

Now, though, rather than serving as a hiding place, the dollar is benefiting from the stock market's surge to new highs and the improvement in U.S. economic data. The dollar nudged down a tad from a seven-month high against a basket of currencies on Thursday even as the Dow Jones industrial average surged to another record high despite interest rates remaining at record lows.

For instance, the dollar has gained fairly steadily against the yen. In January, it was trading at 86.67 yen to the dollar; on Thursday it was trading at 96.06 to the dollar. Likewise, the British pound has fallen from 1.62 to 1.51 to the dollar so far this year.

The moves suggests the dollar has entered a multi-year bull cycle, and marks a major shift in its behavior against other asset classes.

"Certainly, all the pieces are slowly coming into place for a bull market for the dollar," said Paresh Upadhyaya, director of currency at Pioneer Investments in Boston, which had assets under management of $204 billion as of the end of last year.

The dollar has outperformed eight out of nine major G-10 currencies so far this year. Political uncertainty in Italy has re-ignited fear about the euro zone's ongoing debt crisis. Weak economic growth and the prospects of aggressive monetary easing in Japan and Britain have driven the yen and sterling to multi-year lows.

To be sure, there are those who caution that spending cuts from Washington could put a damper on economic growth and the Federal Reserve has pledged to keep interest rates low for the foreseeable future.

Still, capital flows and futures positioning bears out the attitude to U.S. assets.

Cross-border inflows into U.S. stocks are tracking at about $100 billion to $150 billion for 2013, compared with a net neutral level in recent years, according to Nomura Securities. Futures activity shows increased bets on the dollar from speculators.

And stocks are not the only U.S. asset drawing in overseas capital. A recovering commercial property market, where transactions have rebounded by more than four-fold from their post crisis-low in 2009, is also enticing foreign investment.

Purchases of commercial real estate by foreign buyers totaled $24.18 billion in 2012, according to Real Capital Analytics, which tracks the commercial real estate market. That's up 1.6 percent from the year before and the highest annual total since 2007, a year when the dollar index fell 8.4 percent.

Another undercurrent is the shrinking U.S. current account deficit, the difference between what the U.S. imports and what it exports in goods and services and money transfers, and a measure of how much the United States relies on foreign lenders to fund its economic growth.

The gap, a major headwind for the dollar, narrowed to $110.4 billion in the fourth quarter, or 2.8 percent of gross domestic product, down from a peak of 6.5 percent of GDP in 2005. Analysts expect the shortfall to hit around 2.5 percent this year and next.

For Stephen Jen, a managing partner at London-based hedge fund SLJ Macro Partners, the move confirms a long-held theory that the dollar outperforms when the United States either leads the world into a deep recession or a sustained recovery.

The theory, which Jen developed with economist Fatih Yilmaz when both were at Morgan Stanley, is called "the dollar smile," because it creates a U-shaped line on a graph when charted against the relative U.S. growth rate. The dollar would hit the trough of the smile when the global economy is highly coupled and there's little difference in growth between economies.

"The dollar seems to have started to smile again, after being debased by the Fed in the past years," said Jen, who believes the currency is undervalued and "has the potential to stage a broad-based rally against a wide range of currencies."

LIABILITY NO MORE

Strong appetite for U.S. assets from overseas investors has driven the rally in the dollar and stocks in 2013. Foreigners have poured money into U.S. equities in recent months while U.S. demand for foreign assets has waned, in part due to the improved outlook for the U.S. economy.

The 25-day correlation between the U.S. dollar index and the S&P 500 stood at 0.53 on Thursday, so the two indicators are moving in tandem more frequently. In late 2012, the correlation was -0.9, almost a perfect inverse relationship.

Net inflows into U.S. equities surged in the second half of 2013. The four-month moving average of net equity inflows rose to $17 billion at the end of 2012, highest since January 2008, according to Nomura Securities.

Jens Nordvig, global head of currency strategy at Nomura Securities in New York, said the shift in cross-border flows in favor of U.S. equities is notable because it is not a response to risk aversion.

"The underlying trend is starting to be U.S. dollar bullish on the private flow side," he said. "In the past, this has been important for dollar direction. Hence, one should take note."

Investors had become accustomed to the dollar as a hiding place, as its last major rally came when the financial crisis raged in 2008 and 2009. But the last two major bull markets for the U.S. dollar - 1995-2000 and 1980-1985 - came at a good time for stocks, said Greg Anderson, North America head of FX strategy at Citigroup in New York.

BETTING ON THE DOLLAR

Speculators boosted bets in favor of the dollar for a third straight week to $23.57 billion in the week ending March 5, data from the Commodity Futures Trading Commission showed. That's still below a high of nearly $40 billion in June, suggesting positioning is far from extreme levels.

Of course, that's not to say the dollar won't wobble a bit in the short-term. Hefty government spending cuts tied to the sequester could dampen economic activity later this year. For all of the fanfare behind recent moves, the dollar index has still not surpassed levels seen in the summer of 2012, and previous rallies were short-lived.

In addition, a major move in the dollar may still be months away until the Federal Reserve sends a clear hint that it intends to taper its bond purchases.

Bilal Hafeez, global head of FX strategy at Deutsche Bank, said the dollar's surge against the yen makes him think the U.S. currency may be starting a "multi-year uptrend." Since 1995, the yen has always been the last currency to peak or trough against the dollar, he said.

With Japan ramping up monetary easing, investors may revive the yen "carry trade," borrowing with Japanese assets to finance purchases of higher-yielding stocks or commodities. The dollar is up 11 percent against the yen this year and has gained nearly 30 percent from a record low of 75.35 yen set in October 2011.

Ken Dickson, investment director of currencies at Standard Life Investments in Edinburgh, with assets under management of $263.9 billion, said his firm is "very heavily overweight" the dollar, especially against the yen.

"Our positive stance has been maintained for a number of quarters but became more significant in the second half of last year," he said.

(Additional reporting by Gertrude Chavez-Dreyfuss, Ilaina Jonas and Daniel Bases; Editing by David Gaffen, Dan Burns and Leslie Gevirtz)