Stock prices shrug off a dip in the dollar

Like a brilliant hot-air balloon drifting over a crowded stadium, the flight of the dollar transfixed Wall Street. Heads craned early last week as the mighty buck floated to dizzying heights against foreign currencies. By midweek, the central banks here and abroad decided the show was getting out of hand. Under the weight of their concerted sale of $1.5 billion, the dollar plummeted.

The stock market waffled as investors tried to read the swings. Drug and other multinational stocks rose as the dollar dipped. Gains in these stocks were offset by losses in issues that benefit from a strong dollar.

But by Friday, the dollar was regaining altitude and the Commerce Department reported a surprise 1.7 percent jump in the index of leading economic indicators last month. Investors cast indecision aside.

The Dow Jones industrial average galloped past the heralded 1,300 mark, before being reined in by last-minute profit taking. By the final bell, the Dow had dropped but closed at a record high 1,299.36, picking up 23.52 points in five trading sessions.

Meanwhile, the bond market skidded as interest rates edged higher. Once again, Federal Reserve Board chairman Paul Volcker was testifying before Congress and his remarks this time were interpreted to mean a weaker dollar would give the Fed a chance to tighten credit.

Tighter credit fits the scenario for 1985 widely held by corporate economists: a moderately weaker dollar, inflation of 4 to 5 percent, slightly higher interest rates, and a slowing stock market and economy heading into 1986.

Just look at the latest money-supply figures if you doubt the Federal Reserve will tighten credit. This past week, the M-1 surged beyond the Fed's target range, thus threatening to boost inflation. To keep the inflation bogy away, the Fed will have to tighten credit. In the meantime, something must be done about the federal budget deficit.

Or so the logic goes. Now and then, however, one hears a dissenting opinion or two issue forth from the peanut gallery. While the New York brokerage house of Oppenheimer & Co. hardly ranks as an uninitiated observer, the views of research director Francis H. M. Kelly are notedly unorthodox.

``The dollar is in a last die-hard fling,'' Mr. Kelly says. ``It will drop 50 percent in the next few years. We'll see double-digit inflation in three years or less. And the bond market is in a major downtrend.'' As for the Fed, he says it will be forced to loosen the purse strings on the money supply.

Kelly's supporting case is compelling. It does not focus primarily on the federal deficit. Instead, it stems from tackling the trade deficit.

``The trade deficit and the [federal] budget deficit are now inextricably connected. The US must run a trade deficit large enough to finance the budget deficit, or monetize the shortfall in available foreign savings. If the trade deficit overshoots the budget deficit, the economy stagnates or drops into recession,'' Kelly writes in Oppenheimer's March portfolio strategy report.

A flood of cheaper imports lifted the deficit to a record $123.3 billion last year. With no ebb in the dollar's strength, the trade deficit continues to climb. Last week the deficit for January was reported at $10.3 billion, up 28 percent from December.

``It is only a matter of months before imports rise to a new equality, with the expanding budget deficit precipitating a new slowing in economic activity in the second half of '85,'' he writes.

To cut the trade deficit and finance the federal deficit, the Fed must leave the money supply spigots open. This will bring the dollar down and fuel a revival of ``heartland American business,'' Kelly contends.

And the return of competitive pricing (i.e., wider profit margins) would be a boon for farmers, textile manufacturers, forest-product producers, and above all basic smokestack industries.

Once investors discover this, in Kelly's opinion, stock prices will surge.

Fed policy will be aimed at the trade deficit, because cuts in the budget deficit won't come soon enough, if at all, according to Kelly. As shown by the US farmers' campaign last week, ``The victims of the overpriced dollar converge en masse on Washington, screaming for help.'' Such actions ``will make a shambles out of any attempts to reform the nation's finances,'' he says.

As fiscal policies are perceived to have failed to cut the deficits, the Fed will come under increasing political pressure to act. Says Kelly, ``The temptation will be to print more money.''

At the Donaldson, Lufkin & Jenrette brokerage, Gert Von Der Linde also champions the view of looser credit, but for less complicated reasons. ``I think the first quarter is going to be a lot weaker than the Fed now thinks . . . perhaps 2 percent GNP growth or less.''

A weak economy ahead? Shouldn't wise investors greet that news by selling stocks?

``The stock market has a way of discounting the economy better than any other leading indicator, I know,'' Mr. Von Der Linde says. ``The stock market looks right through this sort of pessimism and pounces on the most positive aspect.''

In other words, Von Der Linde expects investors to ignore the economy, as he thinks interest rates will be dropping; the bond market will be in the doldrums; and stocks will provide the best investment option. Chart: Interest rates. Source: Bank of Boston.

Percent Prime rate 10.50 Discount rate 8.00 Federal funds 8.75 3-Mo. Treasury bills 8.92 6-Mo. Treasury bills 8.73 7-Yr. Treasury notes 11.75 30-Yr. Treasury bonds 11.80