With the Dow Jones Industrial Average breaking all time record levels above 12,000 and the markets cheering the return of equity investments, many currency traders may be wondering what is going on in the US dollar.  Shouldnâ�,��"�t the dollar be stronger with the benchmark of the worldâ�,��"�s largest economy rising to tech-boom era levels?  The answer, in theory, is yes.  However, given market dynamics, it seems that the market response is a resounding no.  The sentiment has changed from the idea that what was good for the dollar was good for the Dow, a pre-bubble burst mentality.  Now, it seems the shift has divided the two.  It might be that the significance of the 12,000 level is muted slightly as the economic landscape has shifted with US fundamentals sliding a bit lower than figures witnessed in the late 90s, ie a record trade gap.  Whatever it is, statistically speaking, the positive correlations between the Dow and the US dollar that have emerged are no longer in play.  Instead, the dollar is now facing a negative correlation with stocks.  As you can see in the chart below, over the past 5 years, the EUR/USD actually rallied when stocks rally.  Since 2001, the correlation between the EUR/USD and the Dow has been a positive 50 percent.  This relationship improved significantly over the past few years, with the correlation rising to 75 percent from 2003 to present   A growing trade deficit as well as shifts in central bank demand have contributed to the reversal in reasoning and have left some market participants baffled at the condition of what used to be the worldâ�,��"�s benchmark currency. 

Record High Trade Deficit
According to the US Commerce Department in Washington, the trade deficit for the month of August ballooned to a record pace, rising to $69.9 billion even as exports rose in sync.    Coincidentally, the record trade balance has contributed to an overall dollar hemorrhage of close to $800 billion for the year.  This means in order to actually fund the short fall, US investments will have to attract close to $2 billion a day in order to right the gapping wrong.  Notably, the politically sensitive deficit with China also rose to a record, widening to $22 billion compared to October 2005â�,��"�s record gap of $20.5 billion.   The release is likely to increase further chipping away by the current administration at the Chinese rigidity in calling for increased flexibility in the Yuan and relief for the US dollar in the marketplace. Granted, the import skew is suggestive that consumers are spending more in the economy, it sparks viable concern on the part of foreign and domestic investors alike over the support of the worldâ�,��"�s largest economy.  Furthermore, even though the current administration supports a strong dollar policy as a way to rein in the trade deficit, they hardly practice it as the inherent rewards of dollar weakness are likely to convince even the most enthusiastic American.  Boiling it down to the basics, a lower valued dollar makes US based exports more competitive on the global market place, which should ultimately boost foreign demand along with corporate profits. 

Central Banks Working Behind the Scene
In recent years, central banks have also been working against the US dollar.  With the growing trade deficit and weaker economic outlook hurting the US dollar, key central banks have decided to diversify away from the US dollar, whoâ�,��"�s title as the worldâ�,��"�s number one reserve currency is beginning to wear.  The reason why this trend has taken off in recent years is because central banks are finally getting use to the Euro and understanding how it moves.  As trade activities increase with the Eurozone, it is only natural that central banks increase their Euro reserve holdings as well.  In terms of the Yen, Japan increased interest rates for the first time in six years back in July.  The prospects of higher interest rates in the future have encouraged some central banks to start snapping up the Japanese Yen as well.  This shift has added downward pressure to the dollar as monetary officials are likely mimicking the selling initiative as they look for higher rates of return or a more balanced portfolio.  More specifically, the options have led the Russian central bank in recent days to increase â�,��"foreign exchange reservesâ�,�.  Simply put, it means adding Japanese yen to the mix while diversifying out of dollar positions with overall reserves swelling by almost 50 percent this year alone.  The announcement was not the first as markets have been forewarned over the diversification of South Korean central bank funds as well as Middle East oil parties in the previous year.  With the stalled interest rates in the US, investors are looking elsewhere to other economies where interest rate hikes are increasingly expected. Back in the days of the tech boom, the Euro was too new for central banks to trust diversifying their reserves into. Rates hikes led by the European Central Bank, Bank of England and the Reserve Bank of Australia are shifting focus into their respective economies, taking the steam out of dollar demand.  The move has also purported lessened demand for dollars by a major US investor, China.  Closing in on $1 trillion in dollar denominated assets, Chinese officials are beginning to see no further demand for dollars as they approach the record sum.  With the enormity of holdings, the lack of bidding from the economy adds nothing but bearishness to the market.   

Whatâ�,��"�s It All Mean?
A strong benchmark Dow simply has not translated into strength for the US dollar, fundamentally and statistically speaking.  Now almost 6 years since the tech boom era fed dollar strength, it seems that more external reasoning has kept added pressure on the greenback and turned foreign focus away from American securities, however high they may fly.  Political bantering surrounding a more flexible currency regime of a global competitor and desire for a depreciated dollar are underpinning greenback weakness.  Meanwhile, fueling concern over record deficits is harming underlying economic fundamentals.  Some are already hoping to a return to the time when the dollar and Dow benchmark were correlated for a stronger economy, based on good fundamentals compared to divulging interests â�,�“ but for the time being, until the US reins in its deficit and sees stronger growth, this is unlikely.   With the Dow consolidating for the past week and the US dollar breaking down, a reversal in the stock market could signal a bounce in the dollar while new highs could foreshadow further dollar losses.

Richard Lee is a Currency Strategist at FXCM.