Tuesday, August 19, 2014

What the USD breakout means

In case you missed it, the USD Index staged an upside breakout today.

Should the USD breakout hold and greenback strength continue, here are some of the broader implications of this upside breakout:
  • Bearish for USD denominated yields (and bullish for bond prices)
  • Bearish for commodities

Bond price bullish
I have heard and read comments to the effect that you would have to be insane to lend the US Treasury money at 2.4% for 10 years. With inflation, depending on how you measure it, at or slightly below 2%, it implies a real yield of 0.4-0.7%.

While that view has validity, you also have to consider the alternatives in "safe" asset yields. Today, the 10-year Bund yields is 1.0% and US Treasuries represent a 1.4% spread over Bunds! Not only that, Spanish 10-year yields are at roughly the same 2.4% level and Italian yields are only slightly higher at 2.6%! UK 10-year yields are also at about 2.4%.

In that context, US Dollar assets are not expensive. The rally in the USD is no doubt partly a reflection of demand for USD assets, with Treasury paper a prime beneficiary of this trend, which is bullish for the prices of US Treasury paper.

Commodity bearish
Not perhaps coincidentally, J. C. Parets wrote a post called The problem I see with silver, in which he detailed the technical difficulties that he saw with the silver price.
Here is a weekly line chart showing these lows just below 19 tested successfully 3 times. Where I come from triple bottoms and triple tops are very very rare, if they even exist at all. In all likelihood, as I mentioned on Fox Business in late May, we’ll see a 4th or 5th test that eventually cracks the support. Well as we can see in this chart, we’re seeing just that: a 4th test of support in a commodity that is still in a 3+ year downtrend:

Any problems with silver are likely to extend to gold. The price of gold is also emblematic of the headwinds facing the commodity complex if the USD were to continue to rise, as commodities and the USD tend to be inversely correlated.

I would agree with Parets assessment of the silver outlook and add that the silver-gold relationship is flashing warning signs for gold itself. As the top panel of the gold price chart shows, gold is showing a triangle wedge formation indicating indecision. An upside or downside breakout would indicate the next direction for gold. However, the bottom silver-gold ratio, which measures the more volatile silver price as a barometer for the precious metal complex, is showing weakness. The ratio is nearing a test of relative support. Should that support line break, it would have bearish implications for precious metals. Given the renewed strength in the USD, further weakness in gold, silver and other commodities is the more likely outcome.

As technical analysts, we often overly focus on individual stocks or indices and forget the inter-connected nature of asset prices. This is just a little reminder of the importance of inter-market analysis.

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