An Inference on Interest Rates and Bonds; Euro/Dollar Analysis

I am going to briefly go into some intermarket relationships on bonds, stocks, and interest rates here. This may turn into an actionable trade soon, but it also may be important to consider for those with variable rate mortgages or significant treasury bond investments.

The chart below shows the yield on the Ten Year Treasury Note. As demand for government debt falls so will the price paid for the notes. This means that the note will have a higher yield because of the lower price paid by the investor. Conceptually the investor is demanding a higher rate of return because of higher perceived risk or because of other factors. In this case the investment is in government debt, and so the fear would be that the government cannot meet its debt obligation. Yields often peak in inflationary environments as debt investors (bond buyers) demand to keep up with the rate of inflation.

Typically people view stocks and interest rates as advancing together which means that stocks will move contra cyclically to bond prices. That has historically been most common. However, in the Great Depression in our country and in other comparable economic situations, there came a time when both stock and bond prices declined in tandem. In that case the fear of default as well as forced redemption for income, drove prices of bonds way down which sent yields sky-rocketing.

Now there are various classes and grades of bond quality with government bonds (Treasuries) typically considered the most safe with the least risk of default. So theoretically if demand were to drop off for treasuries (which it has been drastically from foreign debt buyers) that would put pressure on bond prices and drive up yields. If there came a legitimate panic or fear of default on government debt, that would really wipe out demand for Treasuries and drive yields up.

I am bring in this up because of the obvious fundamental concern in the Treasury market right now. The government is piling up debt obligations. Foreign demand for Treasuries has been down hard for a while now, but the Fed as our Central Bank ends up being forced to buy all the bonds and take it on its balance sheet. In turn they have returned the favor by instituting programs and policies that devalue our currency. But it is a fine line to walk, and there is a free market in bonds outside the Fed.

Click on Chart to Enlarge

So here we see on this chart of the Ten Year Note that yields dropped dramatically last fall. That means demand for Treasuries was very high, a so called flight to quality. Since then yields have been rising and the chart formation is looking like a possible inverse head and shoulders pattern, though not confirmed with a breakout of the neckline yet. If this pattern were to confirm it would suggest yields rising up to the 6% area by standard measurement. That would mean a somewhat dramatic drop off in demand for US debt.

Also in support of higher yields are the weekly MACD chart showing a bullish cross at a higher low last week. And the wave pattern is such that there have been 2 strong/fast moves up off the lows followed by shallower slower corrections. The first and second correction have significant alternation in price and time. If the above expanding pattern were forming, it suggests a dramatic increase in yields coming. The wave pattern would also be consistent with the larger chart formation.

Now I am not so much making a prediction here, but more of an observation and inference about the psychology that would accompany the price movement. The psychology would be a decreased confidence in US government debt. The result would be higher interest rates and falling bond prices. This would likely drive mortgage rates up substantially and create further havoc in the housing market. If the move up is so sharp and large as projected above, then there will probably be some serious issues in lesser quality debt.

So the consideration would be whether one should get locked into a fixed mortgage rate and reduce bond investments in favor of cash.

Click on Chart to Enlarge

Now to change gears. The chart above is from FXCM forex brokerage and shows the long and short positioning of their clientele in the Euro/Dollar pair. They are a retail/non-bank brokerage, and thus heavily one sided positioning should be expected to be a contrary indicator. The chart above shows that during almost the entirety of the March to Dec Euro rally, there clientele was net short the Euro and often heavily so. So they were wrong the entire way up. Now we have seen a dramatic decline in the Euro, and suddenly there is a sustained shift to net long the Euro. This is the kind of signal that accompanies a major trend change. It really is amazing when you think about it.

Anyway, this indicates a larger trend shift and to expect a stronger dollar and weaker Euro ahead.

Click on Chart to Enlarge

On a shorter term note though, the FXE Euro ETF showed a doji on the fill of a major gap on the chart. Additionally the daily RSI became oversold. This would argue for a bounce or consolidation before the Euro moves lower. Due to the intermarket correlation, that would be a boost for stocks, but that correlation is starting to break a little, and with light Holiday trading moves may be muted.

So my perspective is that if you are long the US dollar (UUP, EUO, etc) then there are probably substantial gains ahead, but expect a pause in the momentum. Interestingly, wheat and natural gas prices have been correlating mostly positive with the dollar whereas commodities in general move inversely to the dollar. That may be an interesting dynamic of the underlying carry trade on the dollar in that the borrowed dollars may have been used to short wheat and natural gas which were in major bear markets until recent months. So the unwind in the carry trade may be rippling down to those markets. That is somewhat speculative, but the correlations fit, and would argue favoring those commodities relative to others if the dollar continues its rise.