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Oct. 21, 2013, 1:15 p.m. EDT

Dollar to bonds and stocks: Remember 2011?

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About Michael A. Gayed

Michael A. Gayed, CFA, winner of the 2014 Dow Award, is chief investment strategist and co-portfolio manager at Pension Partners, LLC., an investment advisor which manages mutual funds and separate accounts according to its ATAC (Accelerated Time and Capital) strategies focused on inflation rotation. Prior to this role, Gayed served as a portfolio manager for a large international investment group, trading long/short investment ideas in an effort to capture excess returns. From 2004 to 2008, Gayed was a strategist at AmeriCap Advisers LLC, a registered investment advisory firm that managed equity portfolios for large institutional clients. In 2007, he launched his own long/short hedge fund, using various trading strategies focused on taking advantage of stock market anomalies. Follow him on Twitter @pensionpartners and YouTube youtube.com/pensionpartners.

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By Michael A. Gayed

Currency movement is of immense importance given how a marginal movement in exchange rates can cause significant ripples in the global economy and financial markets. From the standpoint of inter-market analysis, the granddaddy of all currencies is the dollar as the world's reserve currency.

As the dollar trends from one direction to the other, it impacts sentiment on bonds, stocks and commodities. A weak dollar tends to be viewed as one way of importing inflation, while a strong dollar exports it. The idea is that if the dollar weakens, it increases the cost of imports (cost-push inflation), while at the same time making goods cheaper to overseas buyers.

If you don't think currencies are crucial to watch, you may be ignoring Japan. The Nikkei has done very well this year because of purposeful efforts by Abe and Kuroda to drive the yen /zigman2/quotes/200725153/composite FXY +0.61% down. The hope is to juice inflation expectations, force higher spending by consumers, and bring in more money to the country through overseas buying.

"Creditors have better memories than debtors."

—Benjamin Franklin

There are limits to this, however, if wages do not rise, and corporations instead keep their excess export-driven profits. The weaker yen, then, for a brief period of time provides some cost-push inflationary pressure, but no commensurate immediate wage pressure higher. This eventually gets treated then as a negative for the economy, as consumers end up spending more for imported goods without increased income, causing weaker growth, and then a self-correcting rise in the currency to adjust for deflationary headwinds as a result.

In the case of the U.S., the relationship of the dollar to the consumer is similar. A weak dollar makes our goods cheaper to overseas buyers. By the same token, goods imported become more expensive, and wages do not increase to match that. Assets rise because corporations keep those excess currency-driven profits, but that in turn becomes seen as deflationary at some point as consumer pressure mounts on spending.

There comes a point where the inflationary "benefits" of a weaker dollar which pushes bond prices down and yields up (inflation-premium repricing) turns to deflationary harm which in turn sends bond prices higher and yields lower (deflation premium repricing).

From this standpoint, markets are now behaviorally starting to look a bit like early 2011. Bond prices have recently strengthened and gotten a nice bid (deflationary). Meanwhile, the dollar is declining (inflationary). This divergence looks like the first part of 2011. Take a look below at the PowerShares DB US dollar Index Bullish Fund ETF /zigman2/quotes/209727862/composite UUP -0.36%  in red with the 10-year Treasury Note Yield Index in black overlayed on top of it. Note that correlations on a rolling 20-day basis have risen between bond yields and the direction of the dollar, similar to 2011.

If yields continue to drop (which does seem plausible given weak growth and inflation expectations), and the dollar itself continues to fall, it might suggest a drop in stocks would soon follow, in turn reversing the dollar's trend and keeping the bid in bonds similar to the Summer Crash of 2011. This could be an important relationship to watch for those getting nervous that stocks have gotten ahead of themselves pricing in reflation which does not exist.

Stocks, most notably the Russell 2000 /zigman2/quotes/209961116/composite IWM -0.14% , and the dollar seem to be suggesting reflation is coming. Bonds continue to disagree. With stock giddiness now at epic proportions, whatever happened to buy low, sell high?

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

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