DOLLAR RISES ON POSSIBLE RATE HIKE -- THAT'S PUSHING COMMODITY PRICES LOWER -- TWO-YEAR TREASURY YIELD HITS THREE-MONTH HIGH -- PROSPECT FOR HIGHER RATES BOOSTS BANKS BUT HURTS UTILITIES -- DOW TRANSPORTS ARE DIVERGING FROM INDUSTRIALS
DOLLAR CONTINUES TO FIRM ... The rally in the dollar that started late last week is still intact. The rally started on Friday following statements from the Fed that seemed to suggest a rate hike sooner rather than later. The daily bars in Chart 1 show the PowerShares US Dollar Index (UUP) bouncing on rising volume since then. The UUP is also trading above its 50-day average. Any hint of higher rates is positive for the dollar, especially with most of the world still in an easing mode. Although the bounce in the dollar is still relatively small, it does appear to be affecting other asset classes. For one thing, it may be weighing on large cap stocks in the U.S. which are more dependent on foreign trade. The prospect for higher rates also explains why banks have been doing better of late, while utilities have been selling off. A bouncing dollar is having a negative impact on stocks tied to commodities. That explains, for example, why energy, gold, and material stocks are the biggest stock losers. Commodity prices themselves are dropping.
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Chart 1
BLOOMBERG COMMODITY INDEX SELLS OFF... The most direct effect of a rising dollar is falling commodity prices. And they are falling. Chart 2 shows the Bloomberg Commodity Index slipping below a rising trendline extending back to January. It's also nearing a test of its August low and 200-day average. Selling in energy, industrial, and precious metals explains weakness in their related stocks. Agricultural commodity prices have been especially weak. Commodity selling is also weighing on developed and emerging markets that export commodities.
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Chart 2
TWO-YEAR TREASURY YIELD RISES... One of the best ways to measure market expectations for a possible Fed rate hike is by watching the direction of shorter term rates, especially the 2-year maturity. Chart 3 shows the 2-Year Treasury Yield climbing during August to the highest level in two months. The 2-year maturity is more sensitive to Fed moves than longer bond maturities. Bond yields also bounced during August, but not as much. That is helping support the dollar. Prospects for higher rates are also boosting financial stocks like banks while hurting utilities.
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Chart 3
BANKS TURN UP WHILE UTILITIES FALL... The prospect for higher rates also accounts for the recent rotation into stocks that benefit from higher rates (like banks, brokers, and insurers) and out of stocks that are hurt by rising rates like utilities. Chart 4 shows the S&P Bank SPDR (KBE) exceeding its June high to reach the highest level since the start of the year. The KBE/SPX relative strength ratio (green line) has been rising sharply as well. By contrast, Chart 5 shows the Utilities Sector SPDR (XLU) falling to the lowest level in three months.. Its relative strength ratio (solid line) has fallen as well. Other rate sensitive stocks like staples, telecom, gold miners, and REITs have also shown relative weakness. Those moves are consistent with expectations for higher rates.
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Chart 4
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Chart 5
DOW THEORY DIVERGENCE... In addition to the prospect for a rate hike, the market has some issues of its own to deal with. One of them is the negative divergence by the Dow Industrials and Transports. Dow Theory holds that an upside breakout by one of the Dow Averages must be confirmed by a similar breakout in the other. So far that hasn't happened. The black line in Chart 6 shows the Dow Industrials having established a record high during August. The red line, however, shows the Dow Transports trading below its July and April peaks. That negative divergence raises concerns about the vulnerability of the Dow Industrials to a downside correction.
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Chart 6
MACD LINES SHOW NEGATIVE DIVERGENCE... Here's another negative divergence weighing on the Dow. Chart 7 shows the daily MACD lines for the Dow Industrials in a negative mode throughout the entire month of August. In fact, the two lines are closer to their June low than their August high. The Dow itself remains in a sideways trading range and above its early August low. A drop below that initial support level, and its 50-day moving average, could cause more selling. Everyone will be watching the job report on Friday to get a clue about a possible rate hike in September. The fact that we're entering the seasonally dangerous month of September may also contribute to a more nervous market. A more cautious attitude is probably warranted.
