US Dollar IndexHi Traders,

The markets are in “thin air” and have taken a bit of a nosedive these past couple of weeks. The inverse correlation between stocks and the US Dollar still holds true and the USD has shown signs of strength since December. This seemingly inexplicable dollar rally is in fact not the result of the weakness in equities, but could actually be the cause of it.

How so?

The 10 month rally we have enjoyed is heavily fueled by the Fed’s easy money policies. The December Fed statement revealed a crucial piece of information which can have an immediate impact on currencies. They announce that the Feds currency swap lines would be closed as of the 1st of Feb as “they were no longer needed”.

The Fed: “The Federal Reserve will also be working with its central bank counterparties to close its temporary liquidity swap arrangements by February 1.”

These currency swap lines were first put in place in September and October 2008 during the peak of the financial meltdown in order to stimulate inter-bank lending. This was actually a smart move on the Fed’s part. Interest rates were surging and these swap lines eased the crunch for us dollars by injecting USD liquidity into the global financial system and preventing a more severe crisis.

US Dollar Index Chart:

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The chart above illustrates the USD squeeze leading up until December 2008 driven by the financial crisis. After the Fed announcement to run these temporary swap lines until April 2009 and once liquidity began to return to the financial system, the USD took a nosedive. Then, another rally up until the April 1st 2009 deadline and a subsequent drop after the policy extension until May 2009. Again, The Fed extended the swap lines until October, then until February 2010.

Short-Term Rally, Long-Term Unchanged.

Since the Fed announcement in December, the USD has made considerable gains and could extend even further should the swap lines actually be closed. This means more short-term downward pressure on stocks, which could cause a sharp drop as described in previous articles (here). This does not change my long-term view and once this USD rally fizzles out, stocks and commodities will bounce back and make new highs.

Stay tuned.

Jordi

MarketSpaceTrading.com

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