Beware Foreign Entanglements

Stocks decline as the dollar's fall reminds traders that international politics matters, too.
Author:
Publish date:

The race in Washington is settled, meaning it is time to turn our gaze back to the rest of the world.

Trouble is, the rest of the world may be growing tired of U.S. assets -- a fate that has negative implications for interest rates, the dollar, monetary policy and, by the transitive property of authority, the stock market.

The idea of China dumping dollar-denominated assets, combined with higher oil prices, overshadowed enthusiasm over strong earnings from, most notably,

Cisco

(CSCO) - Get Report

and

Goodyear Tire

(GT) - Get Report

as the major averages closed down.

The Dow Jones Industrial Average

dropped 0.6% to 12,103.30 as pharmaceutical components

Merck

(MRK) - Get Report

,

Pfizer

(PFE) - Get Report

and

Johnson & Johnson

(JNJ) - Get Report

continued to recoil at the thought of a Democrat-controlled Congress. The Amex Drug Index fell 2.6%.

Meanwhile, the

S&P 500

ended down 0.5% to 1378.33 and the

Nasdaq Composite

fell 0.4% to close at 2376.01 despite Cisco's 6.4% rise and a 1% gain by fellow tech titan

Microsoft

(MSFT) - Get Report

.

The People's Bank of China's Governor Zhou Xiaochuan was just the latest central banker to report that it plans to diversify its reserves out of U.S. dollar assets. The United Arab Emirates, Russia and the Swiss National Bank have all recently stated they will shift away from dollar assets, preferring gold, euros and yen.

"The question always becomes how much is talk and how much is reality," says Ashraf Laidi, chief FX analyst at CMC Markets.

Indeed, most foreign buyers of U.S. assets don't want the dollar to fall too sharply because export-driven economies don't want their currencies' values to rise too far, which would make their exported goods more expensive. Also, these central banks aren't talking about selling

all

of their dollar assets, just some, in order to hedge themselves against a weaker dollar. In other words, they don't want to precipitate a devaluing of the dollar that would unduly diminish the value of their own holdings.

According to a

Reuters

report, Zhou Xiaochuan said Thursday that the bank "is considering various options for diversification" of its reserve holdings. China's central bank reserves topped the $1 trillion mark in late October. The news came on a day when the U.S. trade deficit narrowed more than expected in September, but the deficit with China alone widened to a new record, $23 billion. The overall deficit fell 6.8% to $64.3 billion.

The euro reached a new two-month high at $1.2850 following the news, and the dollar reversed its rally vs. the Japanese yen. The dollar finished the day at 117.92 yen, after reaching 118.58 intraday.

Also, the price of a December-dated gold contract jumped $18.50, or 3%, to close at $636.80 per ounce. Shares of gold-related exchange traded funds also were up sharply on the day. The

streetTracks Gold Shares

(GLD) - Get Report

and the

iShares Comex Gold Trust

(IAU) - Get Report

gained about 3% on the day.

San Francisco Federal Reserve President Janet Yellen couldn't have timed her warning any better. In a speech Monday, Yellen said that Asian countries may reduce their U.S. investments. "There is a mutuality of interest, but that doesn't mean it can't be changed," she said. "Countries may decide to channel less of it into dollar assets."

The diversification trend is not a new idea or threat to the dollar's strength. But Thursday's news is a reminder of several reasons a downswing for the greenback may be at hand.

Foreign central banks might choose this moment to diversify because of the

Federal Reserve's

decision to halt its interest rate-hiking campaign while the rest of the world's central banks continue to tighten. That diminishes the argument for holding dollars, because U.S. interest rates are that much higher than those in the rest of the world.

"The dollar's path may be jagged, but its long-term destination is depreciation against non-dollar currencies, as both a hedge against dollar weakness and a potential source of alpha

read: above-average returns vs. U.S. fixed income benchmarks," writes Richard Clarida, global strategic adviser at Pacific Investment Management Company, or Pimco.

Indeed, the Bank of England raised its overnight borrowing rate by 25 basis points to 5%, stating that its quick economic growth threatens to drive up inflation. The BOE's 5% rate is its highest in five years. The European Central Bank is expected to raise its benchmark borrowing rate by 25 basis points to 3.5% next month, and the Bank of Japan has signaled more rate hikes from its current 0.25% rate as soon as December.

A reduction in foreign buying of U.S. assets may continue to erode the trade deficit, but a weak dollar, or a "5% to 6% drop from here could grease the wheels of inflation" in the U.S., says Laidi.

More inflation could reignite rate-hike fears. For now, the Fed is keeping its monetary policy on "pause" in order to collect data and assess the housing market's decline and the impact of 17 consecutive interest rate hikes from mid-2004 through mid-2006.

But Fed speakers, including Chicago Fed President Michael Moskow, lately have emphasized the risk of inflation over concerns about slowing growth. The rhetoric has not yet caused markets to increase their inflation expectations, but investors seem increasingly frustrated and unsure about the direction of Fed policy.

As of Wednesday, the fed funds futures market seems to have thrown up its hands in frustration and prices in no movement in the fed funds rate until May. As recently as September, the fed funds futures market was pricing in a 50% chance of a rate cut in January. The market flipped the odds to favor a hike sooner rather than later.

For Thursday, the stock market was still digesting the Democratic win in the House and the Senate, while watching the price of oil climb back above $60 per barrel. Also, the University of Michigan survey showed a 1.4% drop in consumer sentiment in November after a 14% jump in the September/October period.

So while it pays to keep your eye on the trees in Washington, don't lose focus on the forest, or the rest of the world.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click

here

to send her an email.