GERMAN DAX HITS RECORD HIGH AS EUROPE STRENGTHENS -- U.S. DOLLAR INDEX RECORDS EIGHT-YEAR HIGH -- SPREAD BETWEEN US AND GERMAN BOND YIELD WIDENS -- U.S. TWO-YEAR YIELD HITS THREE-YEAR HIGH ON STONG JOBS REPORT -- FINANCIALS SHOW MARKET LEADERSHIP
GERMAN DAX CLOSES AT RECORD HIGH ... German stocks sold off Thursday after the ECB delayed further monetary easing until the first quarter. Later reports that more monetary stimulus might come as early as January helped boost European stocks which rallied sharply on Friday. Chart 1 shows the German DAX Composite Index jumping 2.4% on Friday to reach a new record. Other eurozone stock markets jumped as well. France rose 2.2%, Spain gained 2.6%, and Italy 3.4%. Friday's strong jobs report in the U.S. may have also improved market sentiment in global markets. The only laggards were oil producers like Brazil, Canada, and Russia. Oil importers like China and Japan hit three and seven year highs respectively. That puts most global stock markets on a sounder footing. Most foreign currencies fell however as the U.S. Dollar hit a new eight-year high. That was due mainly to a big jump in U.S. rates on Friday following the strong jobs report.
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Chart 1
US DOLLAR INDEX HITS EIGHT-YEAR HIGH ... The monthly bars in Chart 2 show the U.S. Dollar Index ending the week at the highest level since 2006. The USD closed slightly above its 2009 and 2010 highs. Any chart reader will recognize that as a major upside breakout. The USD had fallen between 2002 and 2008 before bottoming. It has traded sideways since then in an apparent bottoming formation. This week's upside breakout has completed that bottoming formation and signals the likely start of major uptrend in the U.S. currency. Chart 2 suggests that the bull market in the dollar has a lot further go both in price and time. Dollar strength is one of the main reasons why commodity markets are in major downtrends. It also explains why commodity exporters are underperforming and commodity importers outperforming on the global stage. The main reason for dollar strength is the growing discrepancy by rising U.S. interest rates and low foreign rates.
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Chart 2
U.S. BOND YIELDS ARE RISING VERSUS GERMANY... I recently posted a chart showing that the 10-Year Treasury yield (2.31%) was significantly higher than the German 10-year yield (0.78%). Chart 3 shows that relationship in a more striking way. The blue line plots the "difference" between the U.S. and German 10-year yields. The rising blue line shows that U.S. yields are not only much higher than Germany's, but that the spread between them is widening. The spread between them has risen significantly since late 2011 and is now at the widest point in several years (1.53%). Currencies values are based on relative comparisons of interest rates. Currencies with higher yields (like the U.S.) do much better than those with lower yields (like Germany). The green area shows a positive correlation between the rising blue line and the trend of the Dollar index. That trend should become even stronger with expectations that U.S. rates will start to move higher in 2016, while ECB monetary easing should keep German rates relatively flat.
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Chart 3
TWO-YEAR YIELD JUMPS TO THREE-YEAR YEAR ... The most dramatic interest rate move on Friday was seen in the U.S. two-year yield which jumped 10 basis points to a three-year high at 0.65%. That was a direct response to Friday's surprisingly strong job reports which showed not only more hiring, but a big jump in wages. That increased expectations for the Fed to start raising short-term rates during 2016. Two-year yields are more reflective of expectations for tighter Fed policy. There again, comparisons with foreign rates are important. While U.S. rates are jumping, the German two-year yield remains a negative -0.011%. That's also dollar friendly.
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Chart 4
FINANCIALS SHOW MARKET LEADERSHIP... Financials were the week's strongest sector. Chart 2 shows the Financial Sector SPDR (XLF) hitting a new high for the year. Two of the strongest groups were banks and life insurers. Arthur Hill showed a number of bank breakouts in his Friday message, so I won't repeat them here. It might be worth pointing out, however, that financials are one of those sectors that stand to benefit from rising U.S. rates. For one thing, rising rates (and a stronger jobs market) should increase demand for bank loans. Banks should also be able to charge higher rates for those loans. Insurers invest most of their premiums in Treasury bonds. Higher yields allow insurers to reinvest maturing bonds in their portfolio in higher yielding bonds. The XLF/SPX ratio (top of chart) jumped to the highest level in two months.
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Chart 5
FINANCIALS ARE ONE OF CHEAPEST MARKET SECTORS... Despite this week's stronger performance by financials, they remain one of the weakest market sectors on a longer-range basis. The weekly bars in Chart 6 show the Financials SPDR (XLF) trading at the highest level since 2008. It is still well below its 2007. It the only market sector that hasn't hit historic highs. The gray area, which plots the XLF/SPX ratio, also shows that financials have been market laggards over the last seven years. That suggests that financials may be finally starting to play catchup with the rest of the markets. Historically low interest rates since 2008 may have something to do with their weak performance. There appears to be a correlation between their relative performance and the direction of the two-year yield (green line). If that's the case, rising rates may start to help their performance.
