The state of the US dollar greatly impacts the equity markets, even though the quantitative easing by the Federal Reserve has skewed their link.
Traditionally a rally in the dollar resulted in an equity market drop. However since January 2012 that has not been the case. The US dollar is range bound, but the S&P 500 has been rallying. But each time the dollar rallies, equities correct a little and then continue to rally.
So this time with the Dollar at a rally point, will the equity markets reverse direction or just correct and continue north. Well that depends on when market thinks the Federal Reserve will taper its quantitative easing.
We are looking at UUP the exchange traded fund that tracks the US dollar index. The index measures the dollar against a basket of six major currencies. You will notice that the dollar is at the lower level of the range from where it has bounced previously. Hence it is likely to do so once again.
The range is shown on the chart by the horizontal lines. The vertical line marks the time when the dollar turned range bound. The dollar is considered a safe haven and equities a risk play. Hence when safety is on risk is off, leading to a fall in equity prices.
As of now we feel that a dollar rally will lead to a correction and not a reversal of the bull market. For a reversal, we would need a tapering of the quantitative easing program. As of now the Fed seems to have the pedal to the metal, which is bullish for even the market that now seems to be tiring and grinding up slowly.
The rally in the equity prices is easily understood. There is just more QE-created dollars chasing almost the same or a slightly higher number of stocks. The puzzling part however is that despite the indiscriminate printing of dollars, its value is still within a range. This could be due to the TINA factor (there is no alternative).
Usually when the dollar is weak investors move money to gold or other commodities. But the commodity markets too are not showing strength, due to which we still have the Dollar moving sideways.
A look at the chart again will show that the dollar is just hovering at the top end of its lower zone. It's possible for the currency to go deeper into that zone before rallying. A further penetration of the zone can lead to a rise in equities.
The position to be right now seems to be long the dollar and short equities. To go long on the dollar, we'd buy the UUP and to short equities we would take positions in index exchange traded funds like the QQQ for the NASDAQ 100, SPY for the S&P 500,DIA for the Dow Jones and IWM for the Russell 2000.
Disclosure: I am short SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.