Stocks were supported on Tuesday despite the plethora of recent poor news on a rumor that Fed Chairman Bernanke will announce the elimination of paying interest on reserves either before Wednesday’s semi-annual monetary policy report before the Senate Banking Committee. The Fed currently pays 0.25%.

To review, the Fed created over $2 trillion of reserves by swapping treasuries for bank’s illiquid toxic assets like residential and commercial mortgage backed securities. To date, banks have been parking the cash at the Fed rather than lending it out in order to obtain a risk-free return. Indeed, Bernanke has repeatedly said that one of the important tools the Fed would use to mop up liquidity, should that day ever arrive, would be to increase the rate it pays on reserves, which theoretically would motivate banks to keep their cash out of circulation at the Central Bank.

The astute observer might ask the following question: If the Fed is desirous of stimulating the economy, why has it been paying interest on reserves all this time when doing so motivates the banks to keep their cash out of circulation? Part of the answer lies in the fact that reducing or eliminating reserve interest remains one of the last “bullets” the Fed has left to fire in its quest to get the economy on a sustained path of growth.

Now, if the rumor does come to pass, it could be as significant as Bernanke’s now-famous 60 Minutes admission on March 15, 2009, when he allowed the interviewer to maneuver him into saying that the Fed was “electronically” printing dollars. Reducing or eliminating interest on reserves could act as the spigot that turns on the flow of dollars into the system, drastically increasing the supply. And with any increase in supply, what generally follows is that price tends to fall.

A falling dollar in this environment will be accompanied by something very important-rising stock prices. In other words, depreciating the dollar is the Fed’s way of re-liquefying the system by building wealth for investors. And as wealth builds, spending, and therefore the economy in general, are supported. It’s the ultimate transference of wealth from the government to the investor class.

Of course, in the present situation, event risk abounds and in this case, the risk comes from the results of European bank stress tests. But if history is any guide, bank stress tests tend to soothe frazzled nerves as evidenced by what happened in the U.S. after the 50 top institutions were put through their own set of tests back in mid 2009, even after it was revealed that a shortage of nearly $75 billion existed.

How low could the dollar go? Well, against the pound, we certainly could see the last swing high from July 15 attained for starters, with an eventual move to the upper 1.55’s. The euro would likely rise to the upper 1.36’s, the mid-April highs from where it slid on the Sovereign Debt Crisis in Greece (and other locales). The Chinese, I strongly suspect, have been buying European government bonds like mad in an effort to support the common currency and no doubt will continue to do so. And as far as the Aussie is concerned, it has bumped up several times against the 61.8 retracement level of the April to May swoon. Once this resistance is surpassed, the way should be clear to at least the lower 91’s.

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