DOLLAR RALLY IS BROADBASED -- SCOTTISH INDEPENDENCE VOTE WEIGHS ON THE POUND -- DOLLAR INDEX APPEARS TO BE FORMING MAJOR BOTTOM -- THAT WOULD BE BAD FOR COMMODITIES, BUT GOOD FOR U.S. STOCKS -- DOW/GOLD RATIO HAS TURNED UP IN FAVOR OF STOCKS
DOLLAR RALLY IS VERY BROADBASED... The U.S. Dollar has become the strongest currency in the world. Although a lot of the attention has focused on the plunge in the Euro, the fact is that all major currencies are falling against the dollar, as shown in Chart 1. Two of the weakest this year have been the Canadian Dollar and the Japanese yen (which has fallen to a six-year low against the U.S. currency). Two of the biggest losers since May have been the Euro and Swiss Franc, both of which have fallen to the lowest level in more than year. The Euro loss has been due to aggressive ECB action to combat a slowing economy and deflation. What may seem surprising is the sharp drop in the British Pound (top line) since the start of July. British bond yields are higher than those in the U.S., and it's generally expected that the UK will start raising rates next spring, even before the Fed. That would normally be supportive to sterling. Reports that the vote for Scottish independence next week (September 18) is closer than expected are being blamed for the plunge in sterling. If the Scots vote yes, the UK has warned that they won't be able to share the pound as their currency. That has unsettled sterling and some British stocks tied to Scotland.
Chart 1
DOLLAR APPEARS TO BE FORMING MAJOR BOTTOM... The monthly bars in Chart 2 plot the trend of the U.S. Dollar Index since 2000. [The USD measures the dollar against six foreign currencies]. The USD peaked in 2002 and fell sharply for the next six years before bottoming during 2008. Since then, it has traded sideways in what appears to be a major bottoming formation. The last monthly bar to the right shows the USD moving up to challenge its 2013 high near 85, and a resistance line drawn over its 2010/2013 highs. A close above its 2013 high (which appears likely) would increase the odds for a new dollar uptrend. Those odds are strengthened by divergent policies between global central bankers -- especially in the eurozone and Japan. Both of those regions are in the middle of -- or just embarking -- on aggressive monetary stimulus to boost their economies. At the same time, the Fed is ending its bond buying program (QE3) during October, and expectations are building that the Fed may be more aggressive in raising short-term rates next year. There are a number of intermarket implications that would likely result from a stronger dollar.
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Chart 2
RISING DOLLAR IS BEARISH FOR COMMODITIES... One of the most conistent intermarket principles is that the dollar and commodities trend in opposite directions. Chart 3 makes that clear by comparing the trend of the U.S. Dollar Index (green bars) to the CRB Index of nineteen commodities (solid area) since 2000. Two major turning points are seen on the chart. The first is that the major upturn in commodities started in 2002 just as the USD was starting a major descent (see arrows). The second major turning point came in mid-2008 when a major peak in commodities coincided with a dollar bottom. 2008 marked the highpoint for commodities, and the lowpoint for the dollar. The two down arrows in 2011 and this year show downturns in the CRB Index coinciding with coincident upturns in the USD (green up arrows). The Correlation Coefficient between the two markets has been negative throughout the entire period, with a current negative correlation of -.72. One of the positive side-effects of lower commodities is that it reduces inflation expectations, which reduces the need for the Fed to tighten monetary policy too fast, and also reduces upward pressure on bond yields. All of those factors are positive for stocks -- and U.S. stock in particular.
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Chart 3
STRONGER DOLLAR FAVORS U.S. STOCKS ... Another side-effect of a stronger dollar is that it favors U.S. over foreign stocks. The black line in Chart 4 plots a "ratio" of the S&P 500 divided by the MS World Index (ex USA) since 2000. The direction of that ratio is overlaid on the trend of the U.S. Dollar Index (green area). The correlation between the two is pretty clear. Between 2002 and 2008 (as the dollar fell) the falling ratio showed U.S. stocks underforming foreign stocks. During those six years, the foreign stock index rose 75% versus an S&P 500 gain of 12%. Since the middle of 2008 (when the dollar bottomed), U.S. stocks have outpaced foreign stocks. An S&P 500 gain of 55% since 2008 compares with a -2.5% loss in the MSWorld Index. A higher dollar could very well widen the margin of U.S. over foreign stocks. [A falling dollar also appears to favor emerging markets more than developed markets, while a stronger dollar appears to favor developed over emerging markets]. One reason why a stronger dollar favors U.S. stocks is that it suggests higher interest rates and a stronger economy. A strong currency also attracts foreign capital to U.S. markets.
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Chart 4
RISING DOLLAR FAVORS STOCKS OVER COMMODITIES ... Here's another side-effect of a stronger dollar. It favors stocks over commodities. The brown line in Chart 5 is a ratio of the S&P 500 divided by the CRB Index. The green matter shows the trend of the U.S. Dollar Index. There again, a positive correlation can be seen. A falling dollar between 2002 and 2008 saw stocks underperform commodities (mainly due to rising commodity prices). The stock/commodity ratio bottomed with the dollar during 2008, and has been rising since then.
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Chart 5
DOW/GOLD RATIO TURNS UP ... A popular way to compare commodities to stocks is theDow Industrial/gold ratio. The orange line in Chart 6 compares the Dow/gold ratio to the Dollar Index over the last 20 yeasr. The reasoning behind the ratio is simple. A weak dollar pushes gold higher. Rising gold prices often coincide with weaker stocks. A higher dollar weakens gold, which usually coincides with stronger stocks. The Dow/gold ratio bottomed during 2011, and started rising during 2012 (as the dollar strengthened). The ratio broke a 12-year resistance line during 2013 which signalled a major shift away from gold and back to stocks. The ability of the S&P 500 to hit a record high during 2013 was the main reason why. In my view, the resumption of the long-term secular uptrend in stocks ended the secular bull market in gold. A rising dollar could widen the gap between the two markets even further. [The last two major bottoms in the Dow/gold ratio took place in the 1930s and the early 1980s. In both instances, stocks did better than gold for decades.
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Chart 6
2-YEAR TREASURY YIELD NEARS THREE-YEAR HIGH... One factor pushing the dollar higher is the fact that U.S. short and long-term yields are higher than most developed foreign markets, and are expected to start rising sooner. [Investors tend to favor higher-yielding markets. Higher rates also imply a stronger economy]. Expectations that the Fed may act more aggressively to boost rates is being reflected in higher short-term U.S. rates, which are more sensitive to Fed actions. The red line in Chart 7 shows the 2-Year Treasury Yield climbing close to a new three-year high. The shorter yield has been rising all year, while the 10-Year T-Note Yield (green line) has been falling. That suggests that fixed income managers have been selling shorter-dated maturities on expectations of tighter Fed policy, and buying longer maturity government bonds (which are supported by lower foreign rates and low inflation expectations). The jump in short-term rates may finally be having an upward influence on longer term rates. The 10-Year T-Note yield jumped today to the highest level in a month. Higher U.S. rates are good for the dollar. But are they good for stocks? A glance at the yield curve may help answer that question.
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Chart 7
YIELD CURVE IS STILL POSITIVE FOR STOCKS ... The yield curve simply measures the difference (or spread) between short- and long-term Treasury yields. The most common measure is the difference between the 10-Year yield and the 2-year yield. The green area in Chart 8 compares the 10 Year - 2 Year yield spread ($YC2YR) to the S&P 500 (monthly bars) since 1990. There have been three periods since 1990 when the yield curve peaked and started to drop (1992, 2003, and 2010-2011). In all three instances, the stock market rallied strongly. Two major upturns in the yield curve from negative territory took place during 2000 and 2007 (red areas). In both instances, stocks fell sharply thereafter. A "negative" yield occurs when short-term rates rise higher than long-term rates, and is usually a warning of a stock market top and likely recession. A steeper yield curve usually results from the Fed's lowering short-term rates to combat a slower economy. That's sign of market stress. A flatter yield curve usually results from higher short-term rates as the economy strengthens. That's where we are now. The fact that short-term rates are starting to rise faster than long term rates (a flatter yield curve) is a sign of rising economic confidence. The danger point will come when short-term rates rise higher than long term. The box in Chart 8 shows we're nowhere close to that danger area. While the prospect for higher short-term rates may cause some short-term stock volatility, Chart 8 suggests it should be positive for stocks over the longer run.
