Since March, the financial markets have been characterized by several generalizable trends, which can pretty accurately be distilled into the title of this post: Dollar Down, Everything Else Up. To illustrate just how intertwined these two trends are, consider that on the same day, “U.S. stocks rose, sending the Standard & Poor’s 500 Index to an 11-month high,” and “The dollar slid to an almost one-year low.” Two perfect to be a coincidence. Look at the charts below, which show the performance of the US Dollar and Emerging Market Stocks, respectively. Subtract out the stochastic fluctuations, and you’re left with two mirror images!

In this case, connecting the dots is not difficult. In fact, I don’t know of any analyst that has argued against an airtight inverse correlation between the Dollar and virtually every other commodity/security/currency. A solid explanation can be found in an earlier Forex Blog post “Dollar Under Pressure on All Fronts,” which detailed both the short-term and long-term drags on the Dollar, but I’ll summarize and expand upon it below for those of you who didn’t read the first iteration.

In the short-term, the Fed’s easy monetary policy is one of the most salient factors. It has injected more than $2 Trillion in US capital markets since the start of the credit crisis, and lowered interest rates close to 0%. In fact, the Dollar is now the cheapest funding currency in the world, recently eclipsing Japan, the perennial home of cheap capital. Moreover, US rates are expected to remain low for the near future. According to one analyst, “Congressional elections in November 2010 represent a strong incentive for the Fed to stand pat. That is because going into an election, there often is political pressure to keep rates low and give a boost to the economy.” This belief is reflected clear in US Treasury rates, which remain relatively close to the all-time lows touched in 2008.

In other words, it’s a classic carry trade scenario, with the US footing the bill. Of course, there’s a twist, namely that there’s so much cash floating around the system, that all of it can’t be invested abroad. Hence, the whopping 58% rise in the S&P 500, from trough to present, as well as the recovery in gold, oil, and other commodity prices. You will find plenty of analysts who point to impressive graphs and quote equally impressive statistics to explain these seemingly distinct instances of appreciation. But from where I’m standing, the fact that everything is under the sun (except for real estate, but that’s another story) is rising would lead the proverbial alien watching from outer space to conclude that investors have adopted a bubble mentality, and are once again chasing returns wherever they can be found.

The strongest support for this explanation can be seen in the fact that signs of US recovery have not been accompanied by Dollar strength. By most estimations, the US economy is now stronger (despite the employment picture) than the UK and the EU, at the very least. Yet the Euro and British Pound have far outpaced the Dollar over the last few months, picking up steam once again over the last few weeks.

You don’t need me to tell you that this is a product of risk aversion; that, ironically, signs that the US economy is strengthening/stabilizing causes investors to move capital out of the US economy. If investors were betting on fundamentals, as stock market bulls would have you believe, this would be plain irrational. But the fact is, US economic growth makes investors more confident in global growth, and causes them to turn towards more speculative investments to achieve yield.

In analyzing whether this phenomenon is sustainable, then, it doesn’t make sense to look at the different markets, in isolation. Rather, you must be holistic in your approach, basically by examining whether investors are justified in their overall complacency. If ever it was the case, it certainly is now: perception is reality.

I toyed with the title of this post for a while, and ultimately settled on the current iteration, because it reflects the battle that is being waged between the Bank of Canada and the forex markets. Simply, the Loonie is moving in one direction (up!), while the BOC would prefer that it moves in the opposite direction.

Let’s start with some context: the Canadian Dollar’s performance this year has been impressive, to say the least. 2009 is far from over, and yet the Loonie has already risen 14% against the Dollar, almost completely undoing the record 18% slide in 2008. Analysts are quick to point to the nascent Canadian economy, fading risk aversion, and the ongoing boom in commodities prices as behind the currency’s rise.

While all of these reasons are certainly valid, they hardly tell the whole story. Consider that Canadian growth remains tepid, deflation is now a reality, its currency is outpacing commodity prices, and its budget deficit will probably set a record this year. Regardless of what the future holds for the Canadian economy, the present remains nebulous. Thus, it seems the best explanation for Loonie strength is not to be found in Canada, but across the border in the US. Specifically, it is US Dollar weakness, and momentum-driven speculation based on the expectation of further weakness, that is driving the Canadian Dollar.

From the Bank of Canada’s standpoint then, the Loonie’s move back towards parity has nothing to do with fundamentals, which is why the BOC maintains that the currency represents a threat to both recovery and price stability. He has a point on the second front, since inflation is currently running at an annualized rate of -.8%, marking three consecutive months of deflation. “The [inflation information] has proved the Bank of Canada’s concerns are justified,” confirmed one analyst.

The Million Dollar Question then, is how far the BOC is willing to go to halt the Loonie’s ascent. Bank of Canada Governor Mark Carnet has already intervened vocally, by repeatedly signaling his displeasure with recent developments in forex markets, and suggesting that all options remain on the table. But rhetoric only goes so far, and after a brief pause, the Canadian Dollar has resumed its rally. “We think [rumors of intervention] it’s 100 percent untrue. I don’t think the bank has the ammunition or the desire to intervene. This is a story about U.S. dollar weakness across the board,” said one trader.

The Bank has already exhausted most of the tools in its monetary arsenal. It recently voted to maintain its benchmark interest rate at the current record low level of .25%, and beyond extending the period of time during which it maintains low rates, there isn’t much more it can do on this front. Besides, conveying an intention to hold rates at .25% beyond June 2010 might not influence investors, who don’t seem too concerned about low yields offered by the Loonie. Moreover, it remains loath to copy the quantitative easing implemented by the Fed and Bank of England, because of the tremendous amount of work required to mop up“that increase in liquidity when the time comes.

In other words, the only thing the BOC can do at this point is to actually intervene, probably by buying US Dollars on the spot market. A couple obstacles are the fact that the BOC hasn’t intervened for over 10 years, and that Prime Minister Stephen Harper is simultaneously trumpeting the importance of “flexible exchange rates” in speeches intended to denigrate China.

In fact, the BOC may not have to get involved, since the consensus among analysts is that the Loonie will trade sideways for the next year. “According to…52 strategists polled by Reuters…In three, six and 12 months, the median estimate of those polled had the domestic currency steady at $1.100 to the U.S. dollar, or 90.91 U.S. cents.” Moreover, polled analysts based their forecasts on a mere 17.5% of intervention, which means that irrespective of the BOC, most forecasters think that the Loonie has reached its potential…for now.

Of course, if the Loonie fulfills estimates at the high end of the poll – especially in the short-term, and if inflation remains negative, the BOC could find itself with no other choice. But for now, investors aren’t holding their breath.