SIDE-EFFECTS OF A STRONGER DOLLAR INCLUDE STOCKS DOING BETTER THAN COMMODITIES -- A STRONGER DOLLAR ALSO FAVORS U.S. OVER FOREIGN STOCKS -- TREASURY BOND YIELD IS RISING FASTER THAN FOREIGN YIELDS WHICH FAVORS DOLLAR AND U.S. STOCKS
U.S. DOLLAR APPEARS TO BE BOTTOMING... The monthly bars in Chart 1 plot the U.S. Dollar Index since 2001. Two major trends are seen on the chart. The first is the major downtrend in the dollar between 2002 and 2008. During 2008, the USD broke its six-year down trendline which ended its bear market. Since then, the USD has trended sideways in what appears to be a major bottoming pattern (see parallel lines). To complete that bullish pattern, the USD would have to clear its 2009-2010 highs. Although that hasn't happened yet, it isn't too soon to consider the possible implications of the dollar becoming the world's strongest currency for the first time in more than a decade. The most obvious implication is that the dollar will do better than most foreign currencies. That makes the dollar a much better bet. Chart 2 shows what has happened to the world's two biggest foreign currencies since the dollar bottom during 2008. The Euro peaked that year and has fallen since then. [The Euro has the biggest weight in the USD]. The orange line shows the Japanese Yen peaking during the fourth quarter and tumbling during this quarter. Forex traders have been buying the dollar and selling the Euro and yen (as well as most other foreign currencies). Currency trends reflect how the world views economic prospects for the various economies. Dollar strength suggests that the U.S. economy is in better shape than most foreign markets. There are other intermarket implications of a stronger dollar. One of the most obvious is its impact on commodity markets.
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Chart 1
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Chart 2
LONG-TERM RATIO ANALYSIS FAVORS STOCKS OVER COMMODITIES... This is the same headline that I used in my February 28 message. That message plotted a relative strength ratio of the S&P 500 divided by the CRB index which had risen to the highest level in a ten years. The message of that chart was that stocks had become a stronger asset class than commodities for the first time in a decade. I mentioned that I thought the rising dollar was the main reason why commodities were underperforming stocks. Chart 3 demonstrates that. The brown line is a "ratio" of the CRB Index divided by the S&P 500 (which is a reverse version of the chart shown in the earlier message). The rising brown line between 2002 and 2008 showed commodities in a stronger position. That occurred while the U.S. Dollar Index (green line) was falling. Since the USD bottom in 2008, however, the CRB/SPX ratio has fallen to the lowest level in ten years. The USD upturns during 2008 and 2011 had an especially negative impact on commodity prices. That's consistent with the intermarket principle that a rising dollar is generally bearish for commodities. The chart also confirms that the rising dollar is a big reason why stocks are now a stronger asset class than commodities.
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Chart 3
A FIRMER DOLLAR ALSO FAVORS U.S. STOCKS OVER FOREIGN STOCKS... This is another headline taken from my February message. The black line in Chart 4 is a relative strength ratio of the S&P 500 divided by the MS World Ex-USA Index (MSWORLD). The green area represents the U.S. Dollar Index. The point of the chart is that the direction of the U.S. Dollar has a strong impact on the relative performance of U.S. versus foreign stocks. A weaker dollar (between 2002 and 2008) favored foreign stocks (a falling ratio). A stronger dollar (between 1995 and 1998 and the five years since 2008) has favored U.S. over foreign stocks (a rising ratio). That's another important side-effect of a rising dollar in the years ahead. Countries that produce commodities (like Brazil and Canada) may also be negatively impacted by weaker commodity prices.
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Chart 4
TREASURY YIELDS ARE RISING FASTER THAN FOREIGN YIELDS... Another factor favoring the U.S. Dollar (and U.S. stocks) is the fact that Treasury bond yields are rising faster than foreign yields. Chart 5 shows the 10-Year Treasury Note Yield ($TNX) rising to the highest level since last spring. But that's only part of the story. The Wall Street Journal reported this morning that the 10-year Treasury Note yield was 0.54 basis points higher than comparable 10-year German government bonds, which is the widest spread between the two since 2010. The spread between U.S. and the British bond yield has also reached a three-year high. The spread between U.S. and the 10-year Japanese bond yield has reached the highest level in two years. That has a number of implications. Rising U.S. rates versus foreign rates favors the U.S. Dollar over foreign currencies. Stronger U.S. rates also suggest that the U.S. economy is expected to do better than foreign markets (which favors U.S. stocks) . Higher Treasury bond yields also mean that U.S. Treasury bond prices have fallen further than comparable foreign bonds. That's because bond prices fall when yields rise. What's bad for U.S. Treasury bond prices is usually good for U.S. stocks. Chart 6 plots a "ratio" of the S&P 500 divided by prices of the Ten Year Treasury Note ($UST). The stock/treasury bond ratio has been rising steadily since the fourth quarter of 2011 and has broken out to the highest level in five years. The rising ratio suggests that investors are indeed selling Treasuries and buying stocks. Not all bond prices are falling however. High-yield bonds are rallying with stocks
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Chart 5
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Chart 6
HIGH YIELD BONDS ARE HIGHLY CORRELATED WITH STOCKS ... One bond category that keeps rising is high yield corporate bonds. Chart 7 shows a strong positive correlation between the S&P 500 and the High Yield Corporate Bond ETF (HYG) over the last two years. High yield bonds usually act more like stocks than bonds. High yields bonds are more dependent on the ability of lower quality firms to pay their debts. When investors are optimistic on corporate earnings (which is reflected in rising stock prices), they're more comfortable buying or holding higher risk junk bonds. That explains why high yield bonds are rising while Treasury prices have been falling. Chart 8 plots a "ratio" of the High Yield Bond ETF (HYG) divided by the 20-Year Treasury Bond ETF (TLT) over the same two years. The gray area represents the S&P 500. The ratio fell during 2011 when stocks were weak. The HYG/TLT ratio has been rising along with stocks since then. The green line shows the ratio breaking out to a the highest level since 2011. That means that investors are buying high-yield bonds while they're selling Treasuries. That's another sign of growing confidence.
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Chart 7
