DOLLAR IS TESTING IMPORTANT SUPPORT LEVEL -- WHAT IT DOES FROM HERE WILL IMPACT THE DIRECTION OF COMMODITIES -- EMERGING MARKETS STOCKS AND CURRENCIES ARE TESTING SUPPORT LEVELS AS WELL-- YIELD CURVE SUGGESTS UPPER LIMITS FOR BOND YIELD
U.S. DOLLAR IONDEX IS TESTING JUNE LOW... The U.S. dollar is in the process of testing a couple of important support lines. Chart 1 shows the U.S. Dollar Index (USD) testing a support line drawn under its June low. That's an important test, because a decisive close below that level would represent a technical breakdown for the greenback. There's even more at stake. The weekly bars in Chart 2 show the USD also testing a rising trendline drawn under its 2011/2013 lows. A decisive close below that line would end the dollar uptrend that's been in effect for the last two years. While that would be bearish for the dollar, and bullish for most foreign currencies, it would also have an important bearing on the direction of commodity prices. For reasons that will be explained shortly, dollar direction may also have some bearing on the direction of emerging markets.
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Chart 1
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Chart 2
WEAKER DOLLAR IS HELPING COMMODITIES ... One of the most consistent intermarket linkages is the inverse relationship between the dollar and commodity prices. Chart 3 shows that inverse relationship very clearly over the last two years. Upturns in the the U.S. Dollar Index during 2011 and earlier this year resulted in falling commodity prices (see arrows). By contrast, a dollar drop last summer produced a commodity bounce. Dollar weakness this summer has produced another commodity bounce. The CRB Index (brown line) has just risen above a falling resistance line (brown line) extending back to its 2011 peak. That's happening just as the dollar is testing the green uptrend line extending back to 2011 bottom. That suggests that commodity prices will need a dollar breakdown to continue their rally attempt. That's true of all commodities, and gold in particular. Stocks tied to commodities (gold and metal miners as well as energy) led the market higher this week. They too will need a weaker dollar and stronger commodity prices to continue their market leadership. Stronger commodity prices would also give a needed boost to emerging markets.
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Chart 3
STRONGER COMMODITIES WOULD HELP EMERGING MARKETS... I've written before about the link between commodity prices and emerging markets. That's because some of the biggest emerging markets (like Brazil and Russia) are commodity exporters, while China is the world's biggest importer of those same commodities. Chinese weakness over the last year has hurt commodity prices which, in turn, have hurt commodity exporters. Chart 4 shows a positive correlation between the CRB Index (brown line) and Emerging Market iShares (red line) over the last two years. Both have fallen together since the start of the year. The good news is that both lines are trying to stabilize (see circle). A 5% bounce in the CRB Index since June has contributed to a 7% bounce in the EEM. Both have to do a lot more on the upside to signal a bottom. Both will probably also need a weaker dollar to accomplish that. A weaker dollar might also take some pressure off falling emerging currencies.
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Chart 4
BRAZIL AND INDIAN CURRENCIES TUMBLE... One of the problems hurting emerging market stocks (and bonds) has been weakness in emerging market currencies. Chart 5, for example, shows the Brazil Real (blue line) and Indian Rupee (red line) trading at the lowest levels in four years. The currencies of Indonesia and Turkey have also come under heavy selling pressure. Part of the reason for the selling is the jump in U.S. Treasury bond yields since May which has pulled money out of higher yielding (and riskier) emerging market assets. A close correlation often exists between emerging market currencies and stocks. As a result, falling emerging currencies make emerging market bonds and stocks less attractive to foreigners. Central bankers have taken steps to stabilize their currencies (selling dollars, raising rates, or buying bonds). A weaker U.S. dollar might also go a long way to help stabilize emerging market currencies along with their bonds and stocks.
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Chart 5
EMERGING MARKET STOCKS AND CURRENCIES ARE LINKED... Chart 6 shows the Emerging Markets iShares (EEM) having bounced off potential chart support formed along last summer's low (see circles). A small pattern of "higher lows" has formed since then which is encouraging. To really improve its chart pattern, however, the EEM needs to clear the red resistance line drawn under its April low and over its July high. To do that, it will need some help from emerging market currencies. Chart 7 shows the Wisdom Tree Dreyfus Emerging Currency Fund (CEW) also testing chart support along its June 2012 and 2013 lows. [The CEW is a basket of eleven emerging currencies including Brazil, Chile, Mexico, South Africa, Poland, Israel, Turkey, China, South Korea, Taiwan, and India]. The CEW bounced at week's end, but still needs to clear its summer high (red line) to signal a bottom. It's probably going to take stronger (or at least stable) emerging currencies to lure global investors back into emerging market bonds and stocks.
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Chart 6
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Chart 7
YIELD CURVE SUGGESTS POSSIBLE RATE TARGETS... With the Fed getting ready to cut back on its bond purchases, Treasury bond yields have been rising. Since the Fed has kept bond yields at artifically low levels, they now seem headed to a more normal level. The question is what is a normal level for bond yields. One way to determine that is by looking at yield curves which measure the difference between long and short-term yields. There are a couple of way of doing that. Chart 8 plots the difference between the 10-Year T-Note yield (currently at 2.80%) and the 3-month T-Bill rate (currently at .03%). That yield curve plotted over the last twenty years shows a ceiling of approximately 3.80%. The current yield curve spread is 2.80%. Assuming short-term rates stay where they are (which is what the Fed is promising), that suggests that bond yields could climb a another 1.00% before reaching its yield curve ceiling. That would suggest a 10-Year bond yield ceiling of approximately 3.90% (one percent above its current level). If short term rates start to rise, that ceiling would be even lower. [A logical chart target would be to the early 2011 yield peak near 3.75%]. Chart 9 shows another version of the yield curve which measures the difference between the 10- and 2-Year Treasury rates. The 20-year ceiling for that ranges from 2.70 to 2.90%. Using the upper number yields a potential upside target of .40 basis points from the current yield curve difference of 2.50%. And that assumes that the 2-year yield doesn't rise much in the near future. That more modest target suggests a 10-Year yield curve target of approximately 3.30% (40 basis points over the current level). The horizontal lines on Chart 10 show where those upper ceilings are for the 10-Year Treasury yield. [Bond yields suffered a downside reversal on Friday from an overbought condition which suggests the possibility of a short-term pullback (and a bounce in oversold bond prices). The long-term expectation, however, is for higher bond yields and lower bond prices].
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Chart 8
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Chart 9
