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Forget the News! Watch the U.S. Dollar Index.

Today the government job report was a disappointment. The housing market has been slumping since the government tax credit has expired. The 10 year Treasury yield is under 3.00 percent which tells us that money is still going into bonds and not stocks. However, the markets have rallied sharply higher since early July. Europe still faces major debt issues despite the $1 trillion bank bailout by the European Central Bank. What is the catalyst for this move higher in the stock market? Is it purely the strong Chinese economy or is there something else at work?

It is the declining U.S. Dollar. Since June 7th the U.S. Dollar Index has declined by nearly 10 percent. If you have not noticed yet the major stock market indexes such as the SPDR Dow Jones Industrial Average (NYSE:DIA) are higher by 10 percent since the July low. Therefore, when the dollar declines the major stock indexes inflate higher. The opposite case can be made when the dollar trades higher the stock market indexes will deflate. Just compare the U.S. Dollar Index to the Powershares QQQ Trust (NASDAQ:QQQQ) or any other major index since March 2009 and you will see the inverse relationship to the U.S. Dollar Index.

The plan by the U.S. Treasury and the Federal Reserve Bank is to inflate the stock market back to health. To there credit since the March 2009 low it has worked. The next major hurdle now for them is to get the U.S. consumer to spend more money. As you all know by now consumer spending accounts for 70 percent of the gross domestic product in the United States.

As for now as long as the dollar declines the stock market indexes rally and the markets inflate higher. The problem comes when the people that are on fixed incomes such as retirees start to complain that their money is buying less the same way it did in November 2009. At that time the U.S. Dollar Index was trading as low as $74.26. In a deflationary environment the ultimate track record of a nation using inflation to defeat deflation is not very good. Japan which is the second largest economy in the world has tried to fight deflation with inflation since 1989 with very little success. In the late 1987 the Nikkei Index traded at 39,000.00 and today it is at 9650.00. When you think about it failure is what makes capitalism work and failure is what may ultimately defeat deflation.

Nicholas Santiago
Chief Market Strategist