Weak dollar may help stocks, bonds rise together - MarketWatch

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By Deborah Levine , marketwatch

That's out of the ordinary. Stocks tend to rise when the outlook for the economy is good and investors are willing to buy riskier assets. When Treasurys advance, in contrast, the economy is typically weakening, prompting investors to seek safety in government debt.

This positive correlation -- the market's equivalent of cats and dogs becoming best friends -- is happening now because of the U.S. dollar, analysts said.

"We're likely to see many more days where Stocks are up, bonds are still bid and the dollar is weaker," said Bill O'Donnell, head of Treasury strategy at RBS Securities.

"U.S. Stock price [gains] will not mechanically translate into lower Treasury prices as we've seen all year until recently," he said.

/quotes/comstock/21z!i1:in\x SPX 1,071 , +6.01 , +0.56%
/quotes/comstock/11j!i:dxy0 DXY 76.35 , +0.47 , +0.61%
/quotes/comstock/31*!ust10y UST10Y 3.38 , +0.13 , +4.10%

Partly driving this unusual trend is the dollar's newfound status as one of the cheapest currencies to borrow among the developed nations. Thanks to the Federal Reserve's moves to drive interest rates to near zero percent, the U.S. dollar carries a low Yield, particularly compared to currencies in Brazil and other emerging markets, where rates are much higher.

The dollar's Yield is likely to stay low for some time. When the Federal Reserve releases its statement on monetary policy Wednesday afternoon, analysts anticipate no change to benchmark interest rates. See preview of Fed meeting.

With U.S. rates on hold, more investors overseas are engaging in bets that the dollar will decline further -- in other words, taking short positions. Or, they're borrowing in the currency to buy higher-yielding assets just to profit from the difference between them, in what's known as the carry trade.

Those strategies might be funding investments in the U.S. stock market. For example, the Standard & Poor's 500 Index /quotes/comstock/21z!i1:in\x ( Index"> SPX 1,071 , +6.01 , +0.56% ) has gone up 15.8% this quarter.

Simultaneously, the falling dollar may be encouraging foreign central banks to buy U.S. Treasurys, either because they are relatively cheaper because of the currency or as part of a plan to support their own currencies.

Treasurys of all maturities have returned 1.18% this quarter, according to an Index compiled by Merrill Lynch.

The dollar index /quotes/comstock/11j!i:dxy0 ( DXY 76.35 , +0.47 , +0.61% ) , a measure of the greenback against a trade-weighted basket of currencies, has lost 5% in the quarter that started in July.

It's happened before

The greenback usually doesn't act as a borrowing, or funding, currency since U.S. interest rates aren't typically the lowest in the world.

But when the dollar has taken the role of a funding currency, a similar phenomenon has occurred: Stocks and Treasurys have risen while the greenback has fallen.

From 1991 to the middle of 1993, the last period when the dollar was the cheapest funding currency in the Group of Seven nations, Standard & Poor's futures rose by roughly 38%, O'Donnell wrote in a research note.

At the same time, 10-year Treasurys rallied, pushing Yields down to 5.74% from 8.13%. Yields and prices move in opposite directions.

Foreign central bank's play

Meanwhile, the low-yielding dollar may be encouraging central banks to buy more U.S. bonds.

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