DOLLAR, GOLD AND INTEREST RATES ARE LINKED -- ASIAN BUYING IS KEEPING US RATES LOW -- RISING EURO AND YEN ARE BULLISH FOR GOLD
WHY LONG-TERM RATES AND THE DOLLAR ARE FALLING... In the normal intermarket course of events, a falling dollar produces higher commodity prices which in time pull long-term interest rates higher. There's no question that the major drop in the dollar since the start of 2002 has contributed to a major bull market in commodities. But interest rates have stayed low. In fact, as Charts 1 and 2 show, there appears to be a fairly close correlation between the dollar and the yield on the 10-year Treasury note over the last year. Both bottomed during the first quarter of last year, both peaked near mid-year, and both are now trading at the lowest levels since the spring of this year. Part of the reason for that unusual coupling may have to with Asian central bank buying.
Chart 1
Chart 2
EVERYONE EXCEPT ASIAN CENTRAL BANKERS ARE CUTTING US EXPOSURE... The Treasury Department reported yesterday that net monthly capital flows from foreign investors declined in August to $59 billion from $63 billion in July, which was the sixth monthly drop this year. That's not too surprising because a falling dollar discourages foreign investment in US bonds and stocks. But those numbers don't tell the whole story. They're even worse. "Private" foreign investment fell by almost half from July to August. While net foreign purchases of US Treasuries fell to an eleven month low, Japanese central bank holdings of Treasuries increased by $26 million in August to $722 billion. China's central bank Treasury holdings increased $5 billion to $172 billion. And therein lies one explanation for the link between a falling dollar and falling bond yields.
EVERY TIME THE DOLLAR FALLS, ASIAN BANKS BUY MORE TREASURIES ... China and Japan both have a vested interest in keeping their currencies from rising against the dollar. That's because a stronger dollar -- and a weak yen and yuan -- are good for Asian exports. The way they keep their currencies from rising is by buying dollars -- especially when the dollar starts to slip. They then take those dollars and buy U.S. Treasuries. As a result, a falling dollar produces higher U.S. bond prices and lower bond yields. The US is applying pressure on China to allow the yuan to rise. Consider the possible consequences. If the yuan rises, the dollar falls. If the Chinese stop buying dollars, they may also stop buying Treasuries. The result would be a falling dollar and rising U.S. interest rates. In September 2003, Japan agreed to let the yen appreciate. The next two charts show that the yen is starting to rise again. The yen is breaking out to a three month high today. Its weekly chart shows that it may be resuming the uptrend that started in September of 2003. Let's hope the Japanese don't stop buying dollars and bonds. There's one market that stands to benefit from these dangerous trends -- and that market is gold.
Chart 3
Chart 4
GOLD IS MAJOR BENEFICIARY ... When the dollar is weak, gold is usually the main beneficiary. That's because gold trends in the opposite direction of the dollar, but in the same direction of foreign currencies. Chart 5 shows that the Euro is also breaking out to the upside today against the dollar. That puts the Euro at the highest level in eight months and on track to challenge its early 2004 peak. Rising foreign currencies are bullish for gold. Charts 6 and 7 show the close link between the Euro and gold. In fact, you can hardly tell the two charts apart. With foreign currencies turning up again, gold should be able to retest its 2004 high near $430. Although gold and its related stocks will suffer setbacks along the way, the longer range prognosis for both remains positive. Unfortunately, the same can't be said for the dollar, US. bonds, and stocks. If these international intermarket trends play themselves out, the dollar can be expected to fall further, bond yields should start creeping higher which would put a damper on the U.S. economy and the stock market. That's one of the reason why my longer-range outlook for stocks is no better than neutral. Commodities should continue to be the strongest asset class over the next few years. And, foreign stock markets should continue to do better than the U.S. market.
Chart 5
Chart 6
Chart 7
GOLD BREAKS OUT IN YEN ... Gold isn't just rising against the dollar. It's also rising in foreign currency terms. That hasn't happened since the 1970s and is a sign of a legitimate bull market in gold. Chart 8 shows what gold looks like when quoted in yen. In other words, this is how it looks to a Japanese trader. The chart paints a bullish picture. It shows yen-denominated gold breaking through its 1996/1997 peaks to reach the highest level in twelve years. Gold is rising when measured against all foreign currencies. That's a long-term bullish sign.
Chart 8
BASIC MATERIALS AND HEALTHCARE PULL S&P 500 LOWER... Buying in some technology stocks like IBM and semiconductors wasn't enough to offset huge losses in basic material stocks (like aluminum, paper, and steel) and health insurers. (Please see today's earlier message for more on the technical damage done to those two groups). The result was a negative market day. The S&P 500 SPDRs fell back below their 50-day moving average. And they did it on heavier volume than yesterday. That's not a good sign. It also puts the late September low in jeopardy once again. Some of our readers have asked if this is time to put some money into the market. Outside of those technology groups (like chips, Internet, and software) that have been showing better relative strength, the best advice I can give on the overall market is to continue watching and waiting.
Chart 9
