MORE ON YIELD CURVE'S IMPACT ON THE DOLLAR, COMMODITIES, BONDS, AND STOCKS -- BONDS PULLBACK WHILE STOCKS TEST OVERHEAD RESISTANCE

WHY A STEEPENING YIELD CURVE HURTS THE DOLLAR AND HELPS COMMODITIES... One of our readers asked me to explain my statement that a steepening yield curve hurts the dollar. Chart 1 shows the track record since 1998. The red line is a ratio of the the 10-Year T-Note Yield to the 2-Year Yield. At the start of 2001, the Fed started lowering short-term rates aggressively to combat a new recession and fear of global deflation. That caused short-term rates to fall much faster than long-term rates and caused the spread between them to widen. That led to a big steepening of the yield curve which lasted into 2003. The U.S. Dollar Index (green line) stopped rising at the start of 2001 and, within a year of the steepening, began a huge decline.

Chart 1

COMPARISON SINCE 2004... Chart 2 shows that generally inverse relationship between the yield curve (red line) and the dollar (green line) has also been evident since 2004. After peaking in 2003, the yield curve started narrowing during the first half of 2004 and continued to drop until the start of 2006. The Dollar Index stabilized in early 2004 and moved sideways until the start of 2006. As the yield curve stabilized in early 2006, the dollar started dropping. The upturn in the yield curve in mid-2007 coincided with another downleg in the dollar to a record low. The reason has less to do with long-term rates than with short-term rates. The yield curve steepens when the Fed is in an easing mode and narrows when the Fed is raising rates. Fed easing usually coincides with economic weakness which hurts the dollar. Fed tightening usually coincides with economic strength which helps the dollar.

Chart 2

THERE'S MORE TO RISING COMMODITIES THAN A FALLING DOLLAR ... Let's bring commodities into the equation. Chart 3 shows the strong inverse relationship between the falling dollar (green line) and rising commodities. The aggressive Fed easing starting in 2001 led to a big drop in the dollar a year later which, in turn, helped launch the major bull market in commodities that same year. A case can also be made that the aggressive Fed easing starting in 2001, which led to a big steepening of the yield curve, also helped launch the commodity upturn. Let's fast forward to the present. One of our readers asked me to "admit" that there is more to the commodity upmove than just a falling dollar, especially since the Dollar Index has been flat since last November while commodities have been soaring (Chart 4). I've never claimed that the commodity rally was based "only" on a falling dollar. Other factors include commodity demand from big emerging countries, low global interest rates, crop sizes and weather conditions. [The fact that agricultural commodities are leading the CRB surge is proof of the last two factors]. The recent steepening in the yield curve is another factor. Chart 5 compares the yield curve to the CRB Index over the last year. That chart shows a pretty close correlation. It's no accident that the last commodity upturn started during August, just as the Fed started its latest easing campaign and the yield curve steepened.

Chart 3

Chart 4

Chart 5

WHAT'S THE IMPACT ON STOCKS ... Another reader asked the impact of the yield curve on stocks. Chart 6 shows their relationship since 2000. There's a generally inverse relationship. A steepening yield curve from 2000 to 2003 coincided with a bear market in stocks. The yield curve peaked in mid-2003 as stocks bottomed. It turned up again in mid-2007 as the market was peaking. How about bonds? Chart 7 shows that there's been a positive relationship between bond prices and the yield curve since 2000. That makes sense. Bonds usually outperform stocks when the Fed is easing (a steeper yield curve), and stocks do better when the Fed is neutral or tightening (flatter yield curve).

Chart 6

Chart 7

BOND/STOCK RATIO ... I know I've shown this ratio before, but it's worth a repeat look. It's a ratio of the price of the 10-Year T-Note (UST) divided by the S&P 500. It simply shows which of the asset classes has done better at various times. The rising ratio from mid-2000 to the end of 2002 favored bonds over stocks. The falling ratio from early 2003 to mid-2007 favored stocks over bonds. Since mid-2007 the rising ratio has favored bonds. [A steepening yield curve usually favors bonds over stocks]. Chart shows the uptrend in the UST/SPX ratio since its July bottom. Although the ratio uptrend is still intact, it's in danger of suffering a short-term setback, especially if the early February low is broken. Let's look at the two markets separately.

Chart 8

Chart 9

T-NOTE PRICES LOOK OVERBOUGHT ... The weekly bars in Chart 10 show that the price of the 10-Year US Treasury Note Price (UST) has reached overhead resistance ranging from 118 to 120 which were formed by prior peaks during 2003 and 2004. The 14-week RSI line is at the most overbought level (over 70) since the end of 2002. Those two factors combined suggest that the bond market rally has gotten overdone and is due for a setback. A setback in bonds would likely produce a bounce in stocks.

Chart 10

BONDS AND STOCKS ARE TESTING 50-DAY AVERAGES ... Given their usual inverse relationship, it's not surprising to see bond and stock prices moving in opposite directions today. Chart 11 shows the 10-Year T-Note Price (UST) threatening its 50-day average. Any close below that support line would signal a bigger setback for bond prices and a likely boost for stocks. Chart 12 shows the S&P 500 moving up to challenge its 50-day line (at 1392) and chart resistance at 1400. The S&P 500 needs to close over both chart barriers to turn its short-term trend higher. MORE AFTER TODAY'S CLOSE.

Chart 11

Chart 12