Dollar a Minor Sour Note in Bulls' Bliss

For stock market bulls, today was one of those green-letter days. But the dollar's failure to follow the lead of equities presents a small kink in the optimists' armor, even if one overlooked by most market participants.

The good news for those long stocks is the Dow Jones Industrial Average rose 1.4%, led by J.P. Morgan Chase (JPM Quote) and Boeing (BA Quote), although 27 of the index's 30 components gained on the session.

The S&P 500 gained 1.5%, owing to strength in a broad number of sectors, as evident in the New York Stock Exchange breadth statistics where winners bested losing stocks 11 to 4. Gainers led by 11 to 6 in over-the-counter trading.

The Nasdaq Composite rose 1.3% to 1890.37 after trading as low as 1841.31, overcoming early weakness sparked by McData's (MCDT Quote) warning and J.P. Morgan's cutting of estimates on EMC (EMC Quote).

Stocks were aided by more evidence of the economy's revival; factory orders rose 1.6% in January, up from 0.7% in December and slightly ahead of consensus expectations. Additionally, the "majority of Federal Reserve districts report[ed] some signs of improvement in economic conditions in January and early February," according to the Fed's Beige Book.

Yet in a continuation of a nascent trend, the dollar faltered despite the latest round of healthier economic data and the equity market's resultant rally. Intraday, the dollar traded at a two-month low of 130.62 yen before trading at 130.65 late in the New York session vs. 132.14 yesterday. Meanwhile, the euro traded as high as 87.66 cents, its best level vs. the greenback since Feb. 22.

Hardcore bears have long warned that any sustained weakness in the dollar would undermine the U.S. equity and bond markets, which have greatly benefited from foreigners' largess in recent years. In addition to curtailing foreigners' demand for U.S. financial assets, a weaker dollar has inflationary implications and could therefore cause the Fed to tighten sooner and more aggressively than most economists currently forecast.

To date, the dollar has defied its skeptics. The U.S. Dollar Index, a measure of the greenback's strength vs. a basket of other currencies, is down 1.2% since late January, but is up more than 6% in the past 12 months and began today within earshot of a 17-year high reached last July.

In fact, most currency analysts believe the dollar will continue to stymie its critics. They contend the greenback's recent slippage is due, ironically, to its strength as well as a confluence of temporary factors supporting the Japanese yen.

"With the dollar at 135 yen last week and the euro at 86 cents, a lot of optimism on the U.S. economy was priced in," said Lisa Finstrom, senior currency analyst at Salomon Smith Barney. "The data has confirmed [the optimism], but the dollar was unable to extend its gains. Even a firmer equity market performance doesn't necessarily lead to demand for dollars."

Following Fed Chairman Alan Greenspan's evenhanded testimony last week, "people are wondering about the pace of the recovery" here, she said. Additionally, as the U.S. recovers, currency traders are looking for signs of improvement in Europe, which is aiding the euro. (Purchasing managers surveys in both the eurozone and U.K. showed noticeable improvements in the past week while today's report on Germany's unemployment contained a less-than-expected rise.)

The yen, meanwhile, is being aided by the approaching March 31 ending of the fiscal year for Japanese businesses.

"Every year there's strength in the yen [in February and March] because Japanese investors and companies repatriate unrealized foreign-based earnings and convert them to yen," said Ashraf Laidi, chief currency analyst at MG Financial Group. "It's a seasonal, periodic manipulation of the books by the Japanese -- a window-dressing operation."

Additionally, measures by Japan's government to encourage companies to buyback shares and restrict short-sellers have aided the Nikkei, which is up 8.5% year to date after a modest gain Wednesday.

That, in turn, has helped support the yen, despite ongoing concerns about Japan's economy. Fitch said today it does not foresee any near-term changes to Japan's sovereign debt rating, but Moody's Investors and Standard & Poor's are far less sanguine about prospects for further downgrades.

Short-term, the dollar may fall under 130 yen but neither Laidi nor Finstrom foresees much potential for further weakness from there. In fact, Laidi predicts the dollar will be back in the 140 yen to 145 yen range by summertime.

Finstrom was less optimistic, suggesting the dollar's upside may be capped by the fact that it remains relatively strong vs. other major currencies. "Optimists on equities are talking about meaningful gains, but I'm not sure they offset expectations on the dollar, where there's not much upside," she said.

The key question is where global funds are headed, Finstrom continued. "The U.S. is still attractive, but there may be better opportunities elsewhere," she said. "Fund flows in general have subsided -- M&A flows particularly -- but when they pick up, we'll have a better idea where people are putting their money."

Notably, the yen got a boost today when Merrill Lynch global strategist David Bowers upgraded his exposure to Japanese (and emerging market) equities while downgrading U.S. and U.K. equities.

"Although we are still skeptical about the medium-term outlook, our research shows that Japanese equities have historically traded like cyclicals," Bowers wrote. Additionally, institutions are "aggressively underweight Japan" and "if the global recovery powers ahead, that will have to change."

Yesterday, Credit Suisse First Boston upgraded its near-term recommendation on Japanese stocks to neutral.

These are glacial changes and certainly not enough to stop U.S. equity optimists from dancing victoriously today. But if these trends in the dollar and global investments continue, the bulls might find themselves on thin ice. Certainly, they bear watching.