Dollar Bulls Embrace Bernanke; Stocks Recoil

While the stock market struggled to sustain early gains and the bond market simply struggled, the dollar got a day of respite Tuesday. The greenback inched higher after Federal Reserve Chairman Ben Bernanke dashed market hopes that the central bank would stop raising rates after next week's presumptive rate hike.

Bernanke's comments Monday evening were followed by Tuesday's report that core producer prices rose more than expected last month. This didn't go down well in the bond pits. The price of the benchmark 10-year Treasury bond fell sharply while its yield, which moves inversely, rose to 4.72%.

Rate fears and higher bond yields also eventually caught up with stocks. After trading as high as 11,335, the Dow Jones Industrial Average dropped 39 points, or 0.35%, to 11,235. The Dow fell despite a 5.5% gain in General Motors ( GM), which rallied on expectations of a deal between Delphi, its bankrupt parts supplier, and the United Auto Workers union.

Rate-sensitive issues, such as homebuilding and financial stocks, however, gave back some of the prior gains posted on hopes of an end to rate hikes. The Philadelphia housing sector index fell 1.8%, led by big declines in Champion Enterprises ( CHB) and Pulte Homes ( PHM).

The S&P 500 dropped 0.6% to 1297 after trading near 1311, while the Nasdaq Composite fell 0.9% to 2294 vs. its intraday high of 2333.

But the dollar, which has remained supported by the Fed's 21-month-long campaign to raise rates, gained 0.5% vs. the euro and 0.7% vs. the yen.

The Dollar's China Syndrome

Currency traders might want to keep an eye on an other development that could quickly end the dollar's newfound strength: Three U.S. senators landed in China on Tuesday for a "fact-finding" mission to determine whether they should push a proposal to impose a 27.5% tariff on Chinese imports.

Their key complaint: China keeps its currency -- the yuan -- artificially low, thereby boosting its exports at the expense of U.S. production and jobs. The U.S. trade deficit with China recently stood at $202 billion.

Sens. Charles Schumer, (D., N.Y.) Lindsey Graham (R., S.C.) and Tom Coburn (R., Okla.) have set a March 31 deadline for a vote on a Senate bill that would impose the tariff should China fail to move more quickly on revaluing the yuan.

China last year allowed the yuan to appreciate 2% vs. the dollar, and the currency has risen another 1% since then. It also made moves last week to allow for more fluctuation in yuan trading.

But the senators, and many in Congress, are calling for a much faster and larger increase.

Besides the threat of the tariff, the U.S. Treasury is also considering branding China a "currency manipulator" in its annual report next month, a move it had refrained from doing over the past two years.

Few, so far, had taken congressional pressures on China as anything more than saber-rattling.

But some analysts now believe that the tariff may become a reality, with China-bashing growing by the day and with Congress emboldened after succeeding to ban a Dubai company from acquiring U.S. ports.

The foreign exchange team at ABN Amro, for one, sees a rising chance that Congress may take action. On top of the Dubai ports story, they see looming mid-term congressional elections as a high incentive for lawmakers to cater even more to nationalism and protectionism.

In addition, the free-trade camp has lost its key advocate in Washington when former Fed Chairman Alan Greenspan retired in February, the ABN Amro team wrote.

Should the tariff become reality, the dollar, bonds and stocks likely would face severe pressure because of the threat of retaliation from China.

China held close to $820 billion in foreign exchange reserves in 2005 -- a number that's expected to top $1 trillion this year -- and it's already looking for ways to diversify away from dollars. It is also the world's second-largest holder of U.S. Treasuries behind Japan. A move on either front, or both, would send bond yields sharply higher.

As for the impact of the tariff itself, ABN Amro says it would reduce the profit margins of multinationals with manufacturing operations in China. "Lower profit potential would presumably cause global equities to sell off."

Nike ( NKE), which reported third-quarter earnings after the close, and many other U.S. firms, have benefited from cheap Chinese production to boost their margins. (Nike's EPS and sales results beat expectations but the stock was recently down 0.65% to $84.40 in after-hours trading.)

Companies such as Wal-Mart ( WMT) -- which said over the weekend it plans to add 150,000 workers in China over the next 10 years -- rely heavily on cheap supplies to sell in the U.S.

Doom-and-gloom scenarios that would result from a tariff imposition therefore sound way too scary to consider lightly, even for congressmen eyeing elections.

According to Ashraf Laidi, foreign exchange strategist at MG Financial, the reason the dollar hasn't flinched about the tariff issue so far is that the forex market still doesn't believe it will materialize.

Chinese President Hu Jintao is slated to visit the U.S. next month, and many observers, including Laidi, believe China will wait until then to announce another small step to revalue the yuan. Laidi expects something in the scale of 1.5% to 2%.

The senators, expecting the revaluation, might have gone to China ahead of the visit to take credit for the move, Laidi suggests.

But this doesn't sound the all-clear for the dollar. Every move to revalue the yuan also gives more room to Japan to relax about a higher yen, which would otherwise put Japanese exports at a disadvantage to China's.

The Bank of Japan, which just began unraveling a policy that kept interest rates near zero and the yen weak, may breathe easier if it believes a higher yen won't derail nascent economic growth.

Likewise, the European Central Bank has signaled its intent to continue hiking rates this year, which supports the euro.

Once again, the one thing that will keep the dollar afloat remains higher U.S. rates. Bernanke is likely aware that a strong dollar has protected the U.S. economy from inflation, notably from higher energy prices.

While he hasn't yet acquired Greenspan's political sway over Washington, Bernanke still has interest rates to ward off the impact of protectionism -- at least that's what the forex market seems to believe for now.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback; click here to send him an email.

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