Is this a correction or has sentiment shifted?

The markets may be undergoing a fundamental shift and it seems this move will be more than just a few days in the making.

First, there was the rally in the U.S. dollar in December, which was big, fast, and attracted a lot of assets as measured by PowerShares DB U.S. Dollar Bullish Fund (UUP). Although it didn’t signal a breakout for the greenback, it had the hallmarks of an initial move that needed confirmation.

Second, was the fact that the S&P 500 Index gained 0.8% during UUP’s 4.9% rally from December 1 to December 22. U.S. dollar up, U.S. stocks up, while iShares MSCI EAFE (EFA) fell 2.7% and iShares MSCI Emerging Markets (EEM) lost 2.3%. This was a reversal of the U.S. stock up, U.S. dollar down trend that was seen over the past few years.

In sum, U.S. dollar assets moved higher, especially for foreign investors. U.S. assets looked less attractive to Americans, but relatively superior to foreign assets.

The pattern is plain and partially repeated itself yesterday and today, as the U.S. dollar rallied sharply against the euro. U.S markets fell, but foreign markets fell harder due to the currency effects.

However, this isn’t an investable trend unless it has legs. It needs a sense of permanence, or at least a cyclical support. Say, a monetary tightening cycle in China and a Republican Senator from Massachusetts.

In addition to monetary tightening in China, the Chinese need a stronger yuan. And in case you missed it, the yuan was upwardly revalued against many currencies in the past two months—only you missed it if you were watching the U.S. dollar-Chinese yuan cross. A stronger U.S. dollar versus most currencies means China gets the benefit of a stronger currency without needing to revalue.

The effects of Scott Brown’s election are only beginning to be felt. The U.S. dollar popped versus the euro following his election and now President Obama is suddenly proposing tougher legislation on the banks. It also appears that instead of ramming through a huge increase in the U.S. government’s debt ceiling, President Obama will first appoint a “deficit reduction commission.”

The perception of the U.S. has been very, very negative for about a decade. Emerging markets, Europe and even Japan, were all viewed more positively. Now, the U.S. government is unexpectedly fighting deficits and getting tough on the banks. Europe and Japan, with worse demographics and similar or worse financial positions, are getting a fresh look and aren't as appealing. Emerging markets dependent on Chinese demand are suddenly in trouble because that country's debt binge may finally be ending.

I'm not 100% convinced that the U.S. dollar is in full on rally mode and the trends of 2009 are over, but a good case for that is building.

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