RISING US RATES SHOULD HELP THE DOLLAR AND COULD HURT COMMODITIES -- WITH RATES RISING BECAUSE OF GLOBAL INFLATION, BONDS AND STOCKS MAY RECOUPLE FOR THE FIRST TIME IN A DECADE

US RATES ARE HEADED HIGHER... All signs are pointing to the idea that U.S. interest rates have bottomed and are heading higher. Today's May CPI report (the real one, not the fake core rate) showed a monthly increase of 0.6%. That's a gain of 4.2% since last May. [The core rate rose 2.3% over the last year]. That puts both numbers over the current Fed funds rate of 2%. A negative interest rate (when the Fed funds rate is below the inflation rate) usually results in higher inflation. In this case, the CPI is more than twice as high as the Fed funds rate. Recent comments from the Fed suggest that it's going to start targeting rising inflation pressures. The only way to do that is to raise short-term rates. The market is already doing that. Treasury yields from two-years to thirty years are all trading at new highs for the year. Chart 1 shows the long-term trend on the 2-Year Treasury Note which is the most sensitive to Fed actions. The chart shows the short-term yield having bounced off chart support formed during 2003 (when the Fed was battling deflation). The 9-month RSI line shows the yield also turning up from the most oversold conditon in seven years. Chart 1 has the look of a major "double bottom" in the making. That has important implications for all financial markets.

Chart 1

RISING RATES ARE BAD FOR BONDS ... Bond "prices" trend in the opposite direction of bond "yields". If bond yields are headed higher, that means that bond prices are headed lower. Chart 2 shows the 10-Year Treasury Note Price falling to a new 2008 low and trading below its 200-day moving average. Bonds are usually one of the biggest casualties of rising inflation. There's at least one way to get around that problem. Chart 3 shows the ProFunds Rising Rates 10 Fund which is a mirror image of Chart 2. That's because the inverse ProFund rises when the 10-Year yield is rising. That's why is called a "rising rates" fund. Chart 3 shows that inverse bond fund trading over its 200-day line.

Chart 2

Chart 3

RISING RATES SHOULD HELP THE DOLLAR ... The U.S. Dollar Index has been in major decline since the start of 2002 and hit a record low earlier this year. One of the main factors driving the dollar lower was aggressive Fed easing starting in 2001 to combat a bear market in stocks, a recession, and fears of global deflation. The dollar selloff since last summer was again caused by aggressive Fed easing to stabilize a faltering economy. If rates have bottomed, with the Fed expected to start raising rates by the end of this year, the dollar should start to do better. The monthly bars in Chart 4 show the US Dollar Index to be at the most oversold level since 2003 (the last time rates bottomed). Chart 5 shows the tendency for the two-year yield (green line) to lead turns in the dollar. Higher US rates should boost an oversold dollar.

Chart 4

Chart 5

A RISING DOLLAR COULD HURT COMMODITIES ... The fate of commodities is largely tied to the direction of the dollar. Chart 6 compares the price of gold (bars) to the Dollar Index over the last ten years. It shows the bull market in gold (and other commodities) starting in 2002 as the dollar was peaking. They've trended in opposite directions since then. The 2002 dollar peak resulted from Fed easing to battle deflation. The 2007 dollar bottom may result from Fed tightening to battle inflation. A dollar bottom could lead to a commodity top. The RSI line shows gold to be reacting from a major overbought condition. Gold has already begun a downside correction in anticipation of rising rates and a higher dollar. Chart 7 shows a strong inverse correlation between the two-year yield (green line) and gold over the last year. The chart also shows that the downside correction in gold began in mid-March as rates started to rise. How much of a pullback the entire commodity group could suffer will probably depend on how high the dollar rises. [While the US may start raising rates later in the year, other central bankers will be doing the same. That may keep the dollar from rallying too far].

Chart 6

Chart 7

STOCK REACTION TO RISING RATES IS UNCLEAR... The question of how stocks might react to higher U.S. interest rates (and a couple of Fed hikes) is a trickier question. On the surface, it would seem to be good for stocks. That's because bond and stock prices have trended in the opposite direction over the last year as shown in Chart 8. Bond prices started rising last summer as the market peaked, and have been falling since March when the market rebounded. That would seem to suggest that some money coming out of bonds should find its way back into stocks. Over the last week, however, that hasn't happened. In fact, we've seen stock prices fall along with bond prices. If that trend continues, that would suggest that the relationship between bonds and stocks may be changing. That reason for that could be the threat of global inflation for the first time in a decade.

Chart 8

FROM DEFLATION TO INFLATION... When I updated my book, "Intermarket Analysis" in 2003, I wrote that a major change had taken place in the relationship between bonds and stocks. Historically, rising rates had been bad for stocks and falling rates good. That also meant that bond and stock prices usually trended in the same direction (with bond prices usually changing direction first). What changed that relationship starting in 1998 was the threat of global deflation coming from Asia (Japan in particular). It started with a collapse in Asian currencies in 1997 which pushed the dollar sharply higher and caused a collapse in commodity prices. One of the reasons the Fed lowered rates so aggressively between 2001 and 2002 was to battle deflation. That had the side-effect of pushing the dollar lower and commodities higher. I wrote in the 2003 book that deflation (which hadn't been seen since the 1930s) produced a decoupling of bonds and stocks. In other words, bonds and stocks trended in opposite directions (meaning that stocks and interest rates moved in the same direction). Chart 9 shows that has been the case in the decade since 1998. The rise in bond yields in 2003, for example, coincided with a bottom in stock prices as investors rotated out of bonds and into stocks. The question now is whether a rise in rates in 2007 will help stocks once again. The reason the answer may be "no" is because rates are now raising on inflation fears. We haven't seen that for at least a decade. If global inflation is the new threat, then bond prices and stocks may revert back to their pre-1998 pattern which is to trend in the same direction. That's why we need to watch how the market reacts to falling bond prices over the next few weeks. If bond prices continue to drop, and stocks don't rise, we could be in for much tougher sailing.

Chart 9

BONDS AND STOCKS DROP TOGETHER ... Chart 10 shows the recent action in the price of Treaury bonds (black line) and stocks (green line). Until until mid-May, the two lines had been trending in opposite directions. In other words, bonds had been falling as stocks rose. Over the past month, however, both prices have fallen. If that trend continues, it would suggest that rising inflation pressures may be having a negative impact on both bond prices and stocks.

Chart 10