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Predicting Dollar and S&P from Bond Rates?

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By WendyBG
December 16, 2009

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The 10 Year Treasury Bond has dropped in price (causing a spike in yield) over the past 2 weeks. The yield is up to 3.6%. It has broken out of its trading range (post-August).

The 10YT yield and dollar usually keep a close ratio. When the 10YT yield rises, it is more tempting to investors. Foreign investors may exchange their own currency for dollars to buy Treasuries, which can cause the dollar index to rise.

The question is: Are bond rates leading indicators of the dollar index? Do rising bond rates point to rising dollar?

And what about a completely different asset class, stocks, indicated by the SPX?

During the August 2008-March 2009 panic period, the dollar skyrocketed because of flight-to-safety buying.

The dollar spike was a break in its longterm downward trend, which began in Feb. 2002, decisively breaking a rising trend. The downward trend began due to Federal Reserve's cuts in the Fed funds rate, which led to lower interest rates across the board (though not as much in the long rates -- Greenspan's "conundrum").

Since the panic began to subside in March 2009, along with even more extreme cuts in the Fed funds rate, the dollar has resumed its decline.

http://www.frbatlanta.org/dollarindex/User/dsp_indexes.cfm

http://stockcharts.com/charts/gallery.html?$USD

The dollar has stayed in an orderly channel during its March - December 2009 decline. However, it has just broken out of that channel.

Washcomp (Jeff) has been warning about a rise in the dollar for the past couple of weeks. I am slow to respond to such warnings, because I look at trends, and the dollar movement was within the trend channel. Now the trend channel is broken. Jeff was right. If this continues, the dollar is rising.

If the dollar is rising, every dollar-correlated asset, including commodities and foreign currencies, will probably fall.

In pre-panic days, the ratio of the dollar index to the 10 Year Treasury yield was stable at about 1.8ish. Since the 2008-2009 panic subsided, the the ratio of the dollar index to the 10 Year Treasury yield has recently been fairly stable at about 2.2ish. This is a significant difference. I think this may show that investors are preferentially holding dollars compared with 10 year Treasuries, compared with pre-panic days.

The 10 Year Treasury yield has spiked faster than the dollar over the past 2 weeks. This ratio has dropped, but is still in its recent channel. To stay in its channel, these two critical variables must move in tandem.

http://stockcharts.com/charts/gallery.html?$USD:$TNX

I am particularly interested in the 10 Year Treasury yield because of its effect on mortgage bonds.

But, according to mungofitch, the 2 year Treasury is more correlated with the stock market than the 10 year Treasury. If I understand mungofitch's explanation, a rise in the 2 year borrowing rate should correlate with a drop in the stock market.

The 2YT yield dropped erratically but consistently starting in March 2009. It has spiked in the past couple of weeks, though the move is still within the noise.

http://stockcharts.com/charts/gallery.html?$UST2Y

However, something interesting emerges when the ratio of the SPX (S&P 500 index) to the 2YT yield is charted.

In the past few months, as the stock market rose while the 2YT yield fell, the ratio of SPX: 2YT yield has climbed smoothly. It reached a maximum on December 1, 2009.

http://stockcharts.com/charts/gallery.html?$SPX:$UST2Y

Take a look at the peaks of this ratio. They occurred in Feb. 2008 (907), December 2008 (1258) and December 2009 (1635).

As we all know, the SPX is at a current year high. However, the ratio is falling, since the 2YT yield is rising faster.

Will this cause a drop in the SPX, as mungofitch suggests and as was seen after the prior peaks?

If "the higher they rise, the harder they fall" holds, it may be a nasty drop.

Or maybe the movements are still within the noise and nothing will happen.

What do you'all think?

Wendy