INTERMARKET REVIEW -- BOUNCING DOLLAR PUTTING DOWNWARD PRESSURE ON COMMODITIES -- BONDS AND STOCKS RECOUPLE
FALLING DOLLAR HAS BOOSTED COMMODITY PRICES... Deflation is one of the main issues the Fed is dealing with. With another Fed decision on interest rates less than a day way, I thought it a good time to review the relationship between the dollar and commodity prices. We've pointed out before that one of the ways the Fed has to combat the threat of deflation (which is falling prices) is to weaken the dollar to raise prices. In other words, to try to create a little price inflation. Over the past year, that strategy has worked in the commodity markets. Chart 1 shows the U.S. Dollar Index dropping from the start of 2002 to the present. Chart 2 shows that commodity prices started rising at the same time. Historically, a falling dollar usually translates into higher commodity prices. This is especially true of gold. Recently, however, commodities have been weakening; and the dollar is starting to bounce from a deeply oversold condition and a level of possible long-term support.
Chart 1
Chart 2
DOLLAR IS OVERSOLD AND BOUNCING... Chart 3 shows that the Dollar Index has reached a level of potential support in the low 90s, which was the low formed during the second half of 1998. The MACD lines are still negative, which suggests that the long-term trend of the dollar is still down. However, the RSI line is below 30, which means that it's due for a bounce. The Dollar Index has climbed to the highest level in a month. Chart 4 shows that the CRB Index hit a five-year high last year. It then backed off from a trendline extending back to 1988 and has weakened since then. Over the past month, the bouncing dollar is putting more downward pressure on commodities prices -- especially gold.
Chart 3
Chart 4
FALLING EURO PULLING GOLD LOWER... The chart of the Euro is a mirror image of the dollar. When the Euro falls, the dollar rises. The chart shows a small "double top" in the Euro starting in late May. It has fallen to the lowest level in six weeks and is now threatening its 50-day moving average. A break of that support line would signal an even deeper correction in the Euro -- and a bigger bounce in the dollar. The gold market, which trades in the same direction of the Euro, is dropping as well. Chart 5 shows gold peaking along with the Euro five weeks ago and falling along with it since then. In Tuesday trading, gold fell $6.50 to close at $346 dollars. That puts gold below its 50-day line. At the present time, however, these do not appear to be major trend reversals. I'm inclined to view them as corrections to long-term trends. A lot may depend on what the Fed does tomorrow. The current thinking is that a 1/2 point cut could weaken the dollar -- and strengthen the Euro and gold. A 1/4 point cut would be positive for the dollar -- and negative for the Euro and gold. That puts the Fed in a quandary. It seems to me that the last thing the Fed wants to do now is strengthen the dollar. That could weaken commodities and gold even further and would be deflationary. The idea is to create inflation. The best way to do that is to keep the dollar weak. At the same time, they want to keep long-term interest rates low.
Chart 5
Chart 6
ASIAN DEFLATION DECOUPLES BONDS AND STOCKS... Deflationary trends coming from Asia contributed to a major decoupling of bonds and stocks starting in 1998. Up to that point, bond yields and stocks trended in opposite directions (which meant that bond and stock prices trended in the same direction). Starting in 1998, however, bond yields and stock prices started trending in the same direction. That's highly unusual, but has lasted until recently. I've said many times before that the only time we've seen that type of unusual behavior is in a deflationary climate. That's why the lowest rates in forty years -- and 12 Fed easings -- haven't helped much. At least not until recently.
Chart 7
Chart 8
BONDS AND STOCKS RECOUPLE?... The next two charts show the 10-year T-note yield and the S&P 500. Since the end of April, they've started to diverge. Stock prices have been rising while long rates have been falling. Or, bond and stock prices have been rising together. If that continues, we think that's a good thing. We also think the main catalyst for that is the Fed announcement on May 6 that it's aware of the deflation threat and ready to fight it. That may only be good, however, if the Fed is able to keep long term rates from rising.
Chart 9
Chart 10
