U.S. Dollar Strengthens on Dubai’s Default: What It Could Mean for the Financial Markets?

Nov 27, 2009

The following represents an email I sent to Catamount clients on November 27, 2009.  I’m publishing the email on my blog because it has particular relevance to topics that I intend to discuss in the near future.

Dear Clients,

The markets produced neurotic action today in the wake of Dubai’s debt default.  The stock index futures were down substantially in overnight trading, but the U.S. markets recovered a lot of the losses in the early hours of today’s trading session.  The S&P 500 Index only lost 1.63% in what promised to be a more precipitous fall. Many traders, anticipating a continuation of the 9 month stock rally, probably treated this as a buying opportunity.  It could be just that – another buying opportunity.

However, any circumstance involving a country defaulting on its sovereign debt warrants close surveillance because many severe market dislocations have occurred on the heels of similar events.  An example would be the Asian Paper Tiger crisis in 1998 which took the S&P 500 down 22%. Given the fragile state of the nascent economic recovery, it wouldn’t take much to rattle confidence in overextended financial markets.  We’ll have a better read on the situation by Monday.

It’s interesting to note that, while investors were dumping commodities and stocks in reaction to the Dubai news, the U.S. Dollar rallied sharply against a broad basket of the world’s currencies.  In other words, investors were apparently fleeing risk assets for the safety of the greenback.  This gives us some insight into how certain markets might respond if global economic conditions falter.

Coincidently, the U.S. Dollar Index rests very near where it bottomed on July 15, 2008.  Oil prices hit all-time highs on July 14, 2008.  In the ensuing 4 months, the U.S. Dollar rallied 20%, oil prices fell 55%, and the stock market shed 40%.  This is not a prediction, only an attempt to point out that this could be a pivotal juncture for the financial markets.  If the dollar reverses and rallies, commodities and stocks may swoon – and this could foreshadow deteriorating economic conditions.   If the dollar breaks below this key support level, the risk trade will likely continue – and maybe the economy will continue to mend.

Best Regards,