S&P Retraces 50%-Where To Now?

Price actually poked just above the 50% retrace level during Wednesday’s session and despite not closing above it still managed to finish the day at the highest level of 2009. This came after New Home Sales for Nov. recorded their lowest level in 7 months and consumer spending rose less than forecast (even as spending rose for the 6th time in the last 7 months).

The big news in forex is that the inverse correlation between stocks and the dollar has apparently dissipated, a trend that accelerated after the Fed gave specific dates for ending many of their emergency lending facilities in their last statement. The factoid that caught my eye was that its central bank liquidity swap program would end by Feb. 1 2010.

At its peak, this was a half-trillion dollar facility which allowed the ECB, BoE and SNB (among numerous others) to swap their respective currencies for dollars in order to fund demands made by their respective banking systems. All such institutions need dollars in order to carry out many transactions and the Interbank Market, where banks lend to each other for various periods, had all but shut down in the wake of the Sept. 2008 collapse of Lehman Bros.

Ending these emergency swap arrangements was a signal to investors of two things. First, it meant that normal functionality was restored to the point where monetary authorities felt it wasn’t necessary and second, it indicated that dollars would be in less supply and would likely become more expensive to borrow.

Another factor that has helped the dollar in Dec. is that the market is now anticipating the Fed will move on interest rates in 2010 primarily because the data is improving dramatically (to the point where some economists are projecting annualized growth of 4% in real terms). There are several caveats here though, because yet to be seen is what will happen to housing once the tax credit expires, how the market for commercial mortgages will fair after the Fed stops buying securities backed by the loans, whether new housing construction can make an improved contribution and whether multinational corporations can maintain their competitive edge if the dollar does indeed continue its march higher.

On that subject, I believe it’s too early to say that a strong dollar trend will continue in 2010. It’s very common for the dollar to gain against the major currencies in the 6 week period between the beginning if Dec. and mid-Jan. so I would need to see this move continue past then in order to have a firm belief in it.

The Fed itself has given no indication whatsoever that it’s getting ready to do anything other than maintain rates at “exceptionally low levels for an extended period.” This however may not be enough to prevent dollar strength because the New York Fed has already begun a pilot program to drain excess reserves from the system via reverse repo transactions which totaled about $180 billion. The important thing for traders to be on the lookout for is any indication that the program is moving from the experimental stage to actual implementation. Once that occurs, all bets are off for any kind of dollar weakness.

In the meantime, as I’ve said on numerous occasions over the past few months, there no real reason for stocks to make any kind of significant decline except on the chance that the entire market will decide to take profits simultaneously. I’m still of the belief that the S&P will hit the pre-Lehman level (1255) at some point during the first quarter of 2010, and I would look at any significant dip as a chance to add to my positions.