THE FED DOESN'T HAVE MUCH CONTROL OVER LONG-TERM RATES -- GLOBAL INFLATION IS THE DRIVING FORCE -- THE DOLLAR MAY BE IN SECULAR DOWNTREND

GLOBAL FORCES MAY BE TAKING OVER ... Everyone's attention will be on what the Fed does tomorrow and what it says while it's doing it. The consensus view (encouraged by the new Fed chairman) seems to be for another quarter point rate hike to 5% after which the Fed will pause for awhile. It's been the "pause" part that has helped the stock market move into new high ground over the last month. At the same time, the idea that the Fed may stop raising rates for awhile has pushed the dollar sharply lower and gold prices to $700. Meanwhile, bond yields continue to hit new four-year highs on a daily basis. It's the action in the last three markets that suggests that the Fed may have less control over the long-term direction of interest rates than everyone assumes. The Fed only controls short-term rates. Long-term rates are controlled by market forces. The Fed has been raising short-term rates since the middle of 2004 in an attempt to boost long-term rates and slow the economy and inflation expectations. Long-term rates failed to rise accordingly and created the famous "conundrum" that Mr. Greenspan talked about. The fact that long-term rates have finally turned up just as the Fed is talking about halting the rise in short-term rates may produce a "reverse conundrum". That means that long-term rates may continue rising no matter what the Fed does.

Chart 1

BOND YIELDS ARE BEING PULLED HIGHER BY GLOBAL FORCES ... Chart 1 shows the 10-year T-note yield climbing above its 2004 high to reach the highest level in nearly four-years. [The spring 2004 peak at 4.90% formed just as the Fed started to hike short-term rates. It took two years for bond yields to exceed that 2004 high]. In my view, two things are pulling U.S. bond yields higher. One is growing signs of global inflation as evidenced by soaring commodity prices. Central banks in Europe and Japan are talking openly about the need to start raising interest rates in those two regions. In other words, global forces appear to be the determining factor in the direction of U.S. bond yields -- not the Fed. I've suggested that deflationary remnants in Japan held bond yields down much longer than anyone expected. Now that Asian deflation has come to an end, the path of least resistance for bond yields is higher. And they've reached a critical level in the U.S. Chart 2 shows a down trendline drawn over the 1994 and 2000 peaks. The yield on the 10-year T-note is now testing that decade-long resistance line. Needless to say, a decisive move over that trendline would leave little doubt that the long-term downtrend in U.S. bond yields has come to an end. It may even be that a pause by the Fed could cause that to happen. Consider that a Fed pause would weaken the dollar even further which would boost inflation expectations in the states. That would most likely boost bond yields even further. Inflation expectations -- and not the Fed -- are the main driving force behind the direction of bond yields. And the direction of inflation appears to be upward -- not just in the states but around the globe. There's little the Fed can do to stop that.

Chart 2

THE DOLLAR IS THREATENING LEFT SHOULDER ... On St. Patrick's Day, I wrote about new signs of weakness in the U.S. Dollar Index. I also wrote about the possibility of a "head and shoulders" bottom being formed (March 17, 2006). Chart 3 is an update of that earlier chart. On March 17, the USD was just starting to fall below 90 (red arrow) after failing a test of its ""neckline" drawn along the 92 level. I suggested that the subsequent decline could be a "right shoulder" in a bottoming formation. I suggested a downside target in the 86-84 zone. The lower number was the bottom of the "left shoulder" formed at the start of 2004 (green line). [That would also represent a two-thirds retracement of the 2005 dollar advance]. As the chart shows, the Dollar Index is now challenging the early 2004 low. That puts the USD at an important support point. For a "head and shoulders" bottom to materialize, two things have to happen. First, the USD has to start bouncing from this level. Second, and more important, it has to clear its neckline near 92. While an oversold bounce is certainly possible from this level, the USD would have to rise a long way to turn its trend back up again. Before getting too carried away with the possibility of a dollar bottom, however, it might be a good idea to look at a longer-range chart of the Dollar Index.

Chart 3

LONGER-RANGE DOLLAR TREND IS DOWN ... Most longer-range studies of the Dollar Index go back to 1990 and show major chart support along the 80 level. The presence of major support along the 1990-1995 lows contributed to a dollar bottom at the start of 2004 and a two-year recovery. There's a strong possibility, however, that those earlier lows will be tested again at some point in the future. That's because the trend of the dollar since 1985 has been down. That longer view of the greenback also puts the 1994-2001 dollar recovery in better perspective. That seven-year dollar rally was nothing more than a 50% retracement of the 1985-1992 decline. The standard definition of a downtrend is a series of lower peaks and lower troughs. The falling red trendline shows that we already have lower peaks. What we haven't seen is lower troughs. The green support line drawn along 80 has held for the last sixteen years. But the longer-range trend suggests that it may not hold for the next sixteen. I suspect that 80 level will be tested again before this year is out. Any violation of that long-term support level would be very bearish for the U.S. currency. Two likely results would be higher gold prices and higher bond yields.

Chart 4

DAMNED IF IT DOES AND DAMNED IF IT DOESN'T... That puts the Fed in kind of a box. If it keeps hiking rates, the stock market won't react well. If it pauses, the dollar may weaken and bond yields may rise. That's because the market may perceive the Fed as falling behind the inflation curve -- just as inflation is starting to pickup. Even if it pauses now, there's a strong chance that it will have to start raising rates at a later date. That's because a pause now will allow inflation pressures to grow even stronger as the dollar falls and bond yields rise.

EDITOR'S NOTE: ... I'll be out of the office tomorrow (Wednesday) and won't be writing a market message. That's probably just as well since initial market reactions to Fed moves are usually suspect anyway. I'll try to make sense out of the various markets on Thursday after things have settled down a bit.