A BULLISH AND BEARISH CASE FOR THE DOLLAR -- THE YIELD CURVE IS POTENTIALLY BEARISH -- GLOBAL MONEY FLOWS, HOWEVER, COULD SUPPORT THE DOLLAR -- WATCHING THE LOONIE

INVERTED YIELD CURVE IS POTENTIALLY DOLLAR BEARISH ... Last Thursday I showed a potential "head and shoulders" bottom forming in the U.S. Dollar. I received a number of e-mails questioning a bullish case for the dollar. The main bearish argument for the dollar has to do with a weakening U.S. economy and the growing likelihood that the Fed may have to start lowering interest rates sooner rather than later. Which got me thinking about a possible link behind the dollar and the yield curve. Chart 1 is an attempt to study their relationship. The green line is the Dollar Index. The reddish line is a ratio of the yield on 3-month T-bills divided by the 10-year T-note yield. [It's the yield curve turned upside down for easier comparison with the dollar]. When the red line is rising, short-term rates are rising faster than long-term rates and usually reflects a tighter monetary policy. That was the case from 1992 to 2000, which saw a generally stronger dollar. The danger point is reached when the ratio moves over 1.0 which represents an inverted yield curve (when short-term rates are higher than long-term rates). That last happened in 2000 which forewarned of a coming recession. The ratio started falling in early 2001 (as the Fed started to lower interest rates) and continued to fall for the next two years. The dollar started falling a year later. The Fed started raising short-term rates in the middle of 2004 which turned the ratio back up again. The dollar bottomed six months later. Short-term rates are higher than long-term rates again and the economy is showing signs of weakness. If and when the Fed starts to lower short-term rates, the ratio should turn back down which could be dollar bearish.

Chart 1

FOREIGN WEAKNESS MAY SUPPORT DOLLAR... One potentially bullish case for the dollar might be the the fact that foreign stock markets are starting to underperform the U.S. market for the first time in four years. That's especially evident in emerging markets which are the weakest of all. Chart 2 is another version of a similar chart I showed last Thursday. Here again, the green line is the Dollar Index. The red line is a ratio of the S&P 500 divided by the Dow Jones World Stock Index (DJW). The chart shows the two lines generally moving in the same direction over the last seven years. It shows that the peak in the U.S. Dollar at the start of 2002 coincided with the start of several years of underperformance by the U.S. stock market. [That makes sense since a falling dollar makes foreign assets more attractive]. The recent downturn in foreign markets (relative to the U.S.) suggests that the period of U.S. underperformance may be ending. If the correlation between the two lines continues, that could start to boost the dollar. Chart 3 gives a closer view of the two lines.

Chart 2

2006 SEES SHIFT BACK TO US STOCKS... Chart 3 provides a closer look at the two lines shown in Chart 2. The red line is the S&P/World Index ratio while the green line is the Dollar Index. Both lines bottomed in May. Since then, the US/World stock ratio has continued to strengthen. If global investors start to abandon riskier markets overseas (especially emerging markets) and start to favor U.S. assets (like Treasury bonds and stocks), it's possible to make a case that the dollar could strengthen as well. [Foreigners have to buy dollars in order to invest in U.S. markets]. At least that's one potentially bullish case for the dollar.

Chart 3

FALLING CRB MAY HURT CANADIAN DOLLAR ... There's another potentially bullish factor for the U.S. Dollar having to do with the Canadian Dollar. The CDW has been one of the world's strongest currencies over the last four years. Chart 4 shows, however, that the Canadian Dollar (blue line) has reached a potential resistance barrier at its 1991 peak (blue circle). The second factor that may start to work against the "loonie" is the recent drop in commodity prices. The orange line in Chart 4 is the CRB Index. Notice that the major upturn in the CDW in 2002 coincided with a similar upturn in commodities. That may be due to the fact that Canada is a big producer of natural resources and benefits from rising commodity prices. If the correlation between the two markets continues, the recent downturn in commodities could start to work against Canada. Any serious weakness in the CDW would give a boost the U.S. Dollar which trends in the opposite direction. [I also mentioned last week that the Canadian stock market has started to weaken relative to the U.S. stock market, which may also be due to falling commodity prices]. Chart 5 shows the two markets peaking together in May. But the CDW (blue bars) has held up better than the CRB (orange line) so far.

Chart 4

Chart 5