RISING DOLLAR AND PLUNGING EURO REFLECT WEAKER ECONOMIC CONDITIONS IN EUROPE -- FALLING EUROZONE BOND YIELDS PULL HIGHER-YIELDING TREASURY YIELDS LOWER AS DEFLATION THREAT WORSENS-- EUROZONE STOCKS ALSO WEAKEN ON UKRAINE TENSIONS AND LOWER RUSSIAN STOCKS
DOLLAR INDEX REACHES 12-MONTH HIGH ... The U.S. dollar continues to strengthen. The daily bars in Chart 1 show the U.S. Dollar Index now trading at the highest level in a year. Its upturn started in May and was followed by upside breakouts during July and August. The fact that the blue 50-day average has risen above the red 200-day average adds more technical strength to the dollar rally (see circle). Although the dollar has gained against most currencies, its biggest gain has come against the Euro. Since May 1, the USD has gained 5.33% versus the Euro, 1.87% against the yen, and 1.61% against the British Pound. The direction of the Euro is especially important because the Euro accounts for 57% of the USD. The stronger dollar reflects a "relatively" stronger U.S. economy. Upwardly revised 4.2% growth in the second quarter GDP contrasts with much weaker conditions in the eurozone. That's being reflected in the plunging Euro which is shown in Chart 2. The Euro peak in May coincided with an ECB announcement of monetary stimulus to combat eurozone deflation. The Euro plunge accelerated last week when Mario Draghi hinted at Jackson Hole, Wyoming that some form of quantitative easing was in the cards. With the Fed planning to end QE in October, the divergent path between the two central banks is dollar friendly.
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Chart 1
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Chart 2
EUROZONE INFLATION FALLS TO FIVE-YEAR LOW... Economic conditions in the eurozone continue to deteriorate. This week's announcement that euro inflation fell to a five-year low of 0.3% put the region dangerously close to deflation (falling prices). Five of the 18 countries in the eurozone are already experiencing falling prices (including Italy which is the region's third biggest economy). That puts a lot of pressure on the ECB to act more aggressively, possibly as early as its meeting this Thursday. The falling Euro has implications for stocks and bonds as well. Money leaving Europe is flowing into higher yielding (and safer) assets in the states. That's especially true of bonds. Chart 3 is an updated version of a chart I showed a month ago (July 30). The green line shows the 10-Year Treasury Note Yield falling to a 14-month low of 2.34%. Most of the buying in U.S. Treasuries (pushing yields lower) is being caused by falling yields in Europe. Although U.S. rates are near historically low levels, they're much higher than rates in Europe and Japan. Japan's 10-year bond yield at .49% is 185 basis points lower than the similar maturity in the U.S. Germany's 10-year yield at 0.89% is the lowest level in history, and 145 basis points lower than the U.S. (the widest spread in 15 years). Compared to Japan and the eurozone, U.S. yields are still pretty high. Just as money has been moving out of the Euro and into the dollar, money has also been leaving lower-yielding eurozone bonds and moving into higher-yielding Treasuries. That suggests that falling Treasury bond yields have less to do with economic trends in the U.S. and more to do with economic weakness in Europe.
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Chart 3
EUROZONE STOCKS ALSO WEAKEN... The falling Euro has also taken its toll in eurozone stocks. The solid blue line in Chart 4 shows EMU Index iShares (EZU) peaking in June and falling to a six-month low earlier this month. It has also broken its 200-day average (red line). During that same time, the S&P 500 hit a record high. The difference in the performance between the two regions is reflected in the EZU/SPX ratio (dashed line) which has been plunging since May (when the Euro peaked). Since May 1, the S&P 500 has gained 6.3% while the EZU has lost -5.6%. The three biggest countries in that region did even worse. France lost -6.3%, Germany -6.8%, and Italy -10.2%. It seems safe to suggest that some of that stock money fleeing Europe has found its way into the U.S. market. That flight is also the result of eurozone exposure to the conflict between Russia and Ukraine.
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Chart 4
FALLING RUSSIAN STOCKS HAVE NEGATIVE IMPACT ON GERMANY... It also seems safe to suggest that the conflict between Russia and Ukraine is taking a negative toll on stocks in the eurozone, especially Germany which is the biggest country in the region. The red bars in Chart 5 shows the plunge in the Market Vectors Russia ETF (RSX) during July coinciding with a sharp drop in Germany iShares (blue line). That's not surprising considering the strong economic ties between the two countries. The 20-day Correlation Coefficient between the two markets (below chart) strengthened during July to a high reading of .81. That being the case, the direction of Russian stocks should have some bearing on the direction of German and other eurozone stocks. The RSX bounced during most of August before falling back at week's end. The RSX also failed a test of its 50- and 200-day moving averages. Not surprisingly, German stocks experienced some selling as well. The direction of Russian stocks may be a good barometer of tensions in the Ukraine. The direction of the Russian currency is also worth watching. The ruble fell to a record low against the dollar this week.
