THE 2-YEAR TREASURY YIELD IS ALSO RISING, BUT NOT AS FAST AS 10-YEAR YIELD -- TREASURY YIELDS ARE ALSO RISING FASTER THAN FOREIGN YIELDS -- THAT'S HELPING PUSH THE US DOLLAR INDEX TO THE HIGHEST LEVEL IN THIRTEEN YEARS
TWO-YEAR TREASURY YIELD ALSO HITS NEW 2016 HIGH... Most recent attention has been focused on the surge in the 10-Year Treasury yield to the highest level since last December (middle line in Chart 1). That's based on expectations for stronger economic growth and higher inflation. It's also based on expectations for higher short-term rates and a Fed hike next month. Fed fund futures now place the odds for a December rate hike in excess of 90%. The lowest line in Chart 1 shows the 2-Year Treasury Yield (which is more sensitive to a Fed rate hike) also rising to the highest level since the start of the year (see circle). Longer date bond yields, however, have risen even faster. That can be seen by the top line which plots the yield spread between the 10 and 2 year Treasury yields (the yield curve). That combination of rising short and long term Treasury yields has pushed the U.S. Dollar to the highest level in thirteen years. Global bond yields are also rising. But Treasury yields are rising even faster. That's also dollar friendly.
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Chart 1
TREASURIES ARE LEADING GLOBAL BOND YIELDS HIGHER... Another reasons why the dollar has gotten so strong this month is that U.S. bond yields are moving up faster than foreign yields. The Wall Street Journal pointed out this morning that the premium (or spread) between 10-Year Treasury and 10-Year German yields has climbed to the highest level since 1989 (27 years ago). Chart 2 shows the Treasury- bund yield premium surging this month above its spring 2015 high. The lower line shows the premium of the 10-Year Treasury yield over the 10-Year Japanese bond surging to the highest level in nearly three years. That also explains why the Euro and yen have been falling against the dollar (more on the yen shortly). Treasury yields have also risen faster than UK yields this month. All of which leads us to this week's bullish breakout in the Dollar Index.
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Chart 2
US DOLLAR INDEX HITS 13-YEAR HIGH... The monthly bars in Chart 3 show the US Dollar Index ($USD) trading at the highest level since 2003. [The USD measures the dollar against six foreign currencies with the two biggest being the Euro and yen]. There are a number of possible intermarket effects of a rising dollar. One of the most obvious is that a rising dollar depresses commodity prices, especially precious metals. It may have less of an effect on more economically-sensitive groups like energy and industrial metals. A stronger dollar also favors smaller stocks over large multinationals. That's because large U.S. stocks lose some competitive advantage selling their goods overseas as U.S. exports become more expensive. Globally, a rising dollar is potentially bad for emerging markets, especially commodity exporters. Those higher-yielding (and riskier) markets lose some appeal with rising bond yields in developed markets. Finally, a rising dollar increases the need to hedge out currency risks when investing in foreign markets.
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Chart 3
FALLING YEN BOOSTS NIKKEI INDEX ... My October 6 market message suggested that the Japanese yen was peaking which would give a boost to export-oriented Japanese stocks which appeared to be bottoming. Since then, the yen has fallen to the lowest level in six months against the dollar, and has fallen below its 200-day average (Chart 4). At the same time, the lower box shows the Nikkei 225 Index rising to the highest level since January (based on today's higher close). But that's only part of the story. That earlier message explained that foreign investors (like Americans) buying Japanese stocks need to hedge out the negative effects of a falling yen. As explained at the time, the easiest way to do that is through the Wisdom Tree Japan Hedged Equity ETF (DXJ).
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Chart 4
DXJ OUTPACES EWJ... As I've explain in the past, foreign stock ETFs traded here in the states are quoted in U.S. dollars. As a result, they tend to do worse when the dollar is rising against the local currency (like the yen). Since October 1, for example, Japan iShares (EWJ) have actually lost value (-1.5%) despite a nearly 10% gain in Japanese stocks. By comparison, the Wisdom Tree Japan Hedged Equity ETF (DXJ) has gained 10% over the same time span. The difference between the two Japanese stock ETFs is mainly an -8% drop in the yen. Chart 5 plots a ratio of the DXJ divided by the EWJ since the start of the year. The ratio started rising during October as the yen started to drop, and has risen to the highest level in nearly eight months (meaning the DXJ is doing much better than the EWJ). That's because the DXJ hedges out the negative effect of a falling yen. The same principle holds when investing in other foreign markets. This week's upside breakout in the dollar increases the need for hedging out the negative effect of falling foreign currencies when buying foreign stocks.
