ANOTHER WEAK CPI REPORT BOOSTS BONDS AND STOCKS -- BOND YIELDS DROP ON EXPECTATIONS FOR LESS AGGRESSIVE FED -- RISING BOND YIELDS CAN BE BAD FOR TECHNOLOGY STOCKS -- FALLING DOLLAR REDUCES NEED TO HEDGE FOREIGN CURRENCY RISKS

BOND YIELDS DROP ON LACK OF INFLATION ... June's CPI report showed no change from the previous month, reflecting the absence of inflation. Its annual gain of 1.6% was the smallest since last October. Excluding food and energy, the core CPI saw a modest monthly bounce of 0.1% (for an annual rate of 1.7%). The main reason why the core CPI is slightly higher than the headline number is the exclusion of food and energy. While food prices were flat, energy saw a June drop of -1.6% (more on that later). Given the Fed's growing concern with low inflation, those numbers are lowering market expectations for further rate hikes. As a result, bond yields are falling as bond prices rise. Chart 1 shows the 10-Year Treasury Yield dropping in Friday trading. Stock prices are rising along with bonds. Utilities, which usually rise with bond prices, are one of the day's strongest sectors. Bank stocks, which suffer from falling yields, are the weakest. Foreign stocks are also rising, especially in emerging markets. The dollar is falling along with bond yields (more on that shortly). The combination of a weak dollar and falling rates is boosting gold along with most other commodities.

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Chart 1

FALLING RATES ARE BOOSTING TECHNOLOGY STOCKS ... One of the lesser known intermarket relationships is the inverse link between bond yields and technology stocks' relative performance. That make some sense. Growth stocks like technology don't need a stronger economy to thrive. In fact, they do better in a slower economy which is usually associated with low interest rates. Value stocks (like banks) do better in a stronger economy with rising bond yields. Let's take a look. The black line in Chart 2 is a relative strength ratio which divides the Technology SPDR (XLK) by the S&P 500. The green line plots the 10-Year Treasury Note yield. The two lines have tended to travel in opposite directions over the last fifteen years. The upturns in bond yields in 2003 and 2013 resulted in tech underperformance (red arrows). [The Fed's taper tantrum during 2013 pushed bond yields sharply higher and hurt tech performance]. Downturns in yields during 2008 and again in 2014 boosted tech performance (black arrows), which continued into the second half of 2016.

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Chart 2

MORE RECENT HISTORY ... Chart 3 examines the same link between bond yields and tech performance over the past year. The jump in bond yields last November (following the presidential election) caused technology stocks to underperform the rest of the market (first red arrow). The tech/SPX ratio started rising again after rates peaked near the end of 2016, and especially after they started dropping between March and June. More recently, the drop in the tech ratio during the second half of June occurred while bond yields were climbing. [The jump in bond yields that month caused a rotation out of tech dominated growth stocks into value stocks like financials]. Following today's drop in bond yields, techs are the day's strongest sector, while financials are the weakest. All of which suggests that technology traders are well advised to keep a close eye on the direction of bond yields. Despite low inflation readings, longer range trends continue to favor higher global bond yields. That's especially true if foreign central bankers follow through on their talk of tapering their bond holdings or hiking rates (as the Canadians did on Wednesday). Rising global bond yields could make the going tougher for technology stocks. Which is why tech traders should also be keeping a close eye on inflation trends. Continuing low inflation should act as a restraint on central bankers like the Fed. Any serious uptick in inflation during the second half of the year could change that and cause profit-taking in technology stocks.

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Chart 3

TO HEDGE OR NOT TO HEDGE ... I've written before about another side effect of a falling dollar being that it makes foreign stocks more attractive to American investors. That's because they get the dual benefit of rising foreign stocks and currencies. Dollar strength over the past few years made it necessary for American investors to hedge out the risk of falling foreign currencies. The falling dollar this year has reduced the need for currency hedges. Let's start with the eurozone. The blue line in Chart 4 plots a ratio of the MSCI Eurozone iShares (EZU) divided by the WisdomTree Europe Hedged Equity Fund (HEDJ). The HEDJ hedges out the negative impact of a falling Euro. The blue line trends opposite the U.S. Dollar Index (green line). The reason is simple. A rising dollar translates into a weak Euro. That hurts eurozone stock holdings for American investors. That makes it necessary to switch to an ETF like the HEDJ that hedges out the negative effect of a falling currency. When that happens, the hedged ETF outperforms the EZU and the blue line falls. This year, however, is different. That's why the blue line is rising. That means that the eurozone stock ETF (EZU) is doing better than its hedged ETF. That pattern will continue as long as the dollar is weakening and the Euro keeps rallying. And that's the case in virtually all foreign markets. With one possible exception. That would be Japan.

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Chart 4

YEN FALLS AS NIKKEI RISES... Chart 5 demonstrates that a rising Japanese stock market (orange line) is usually associated with a falling yen (green line). That increases the need for a currency hedge when buying Japanese stocks. The decision by the Japanese central bank to hold its 10-Year bond yield at zero while bond yields around the world are rising has made the yen the weakest of the major developed foreign currencies. Since last July, for example, the Nikkei stock index gained 19%. At the same time, the yen has dropped nearly 9%. The drop in the currency greatly reduced stock profits for American investors. Hence, the need to hedge (or not). The orange line in Chart 6 plots a ratio of the WisdomTree Japan Hedged Equity Fund (DXJ) divided by Japan iShares (EWJ). A falling yen last year caused the hedged ETF (DXJ) to do much better than the EWJ. It's not as clear this year. After falling during the first four months of the year (as the yen strengthened), the ratio has risen since April (as the yen weakened). But the ratio is now up against some overhead resistance (see trendline). The odds still favor the currency hedge, but the case isn't as clear as in other foreign markets. It all depends on the direction of the yen. Americans investing in Japanese stocks might want to track the DXJ/EWJ ratio for guidance on whether or not to hedge currency risk.

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Chart 5

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Chart 6

TWO CENTRAL BANKERS AT A BAR... Two Fed governors walk into a bar. One says to the other "I can't explain another weak CPI reading. No sign of inflation anywhere. After five years, it's getting harder to call it temporary. I just don't understand what's keeping it down". The other governor suggests that energy prices fell -1.6% during June which was one of the CPI's biggest drops. "Maybe that had something to do with it". The first guy reminds him that they're not supposed to look at that. "Maybe it's another drop in cell phone costs. That must be it". Other guy says "I filled my gas tank this morning and was shocked to see gasoline prices so low. I read somewhere that they're 20% lower than in January. Maybe that has something to do with weak inflation". First guy tells him he must be crazy. "Every economist with a PhD knows the price of gasoline has nothing to do with inflation". [Sorry, but this is the best I could do on short notice. Be sure to fill up your tank this weekend while the price is so cheap].