Last week was one of those times where you watch the markets trade on pins and needles. With the continuing issues in Europe, the dollar made a huge breakout against the Euro (see Figure 1), but it also strengthened significantly against the Japanese yen. Normally a strong dollar would have significantly bearish near term implication for equity prices, but the sell-off of long-term U.S. Treasury bonds helped to stabilize equity prices as the flight to quality never transpired.
Figure 1- U.S. Dollar Index Futures
The breakout in the U.S. dollar index futures in January led the bearish breakdown in U.S. equities. This time around, the flag breakout failed to produce the same results. It’s not to say that a strong dollar and equity prices can’t co-exist, but it’s that policies or the economics haven’t changed in the U.S. As always, the strength or weakness in a currency is always relative to what it’s being compared to, and right now investors want to hold U.S. dollars.
In Figure 2 you’ll find a chart for the 10-year U.S. Treasury note. With the passage of the healthcare bill you had a sense that something was going to happen to U.S. Treasuries, but it was the strength in the dollar that muddied the water quite a bit. Apparently people want to hold our currency for the time being and not our debt. However, the appetite for corporate debt has remained strong and may help confirm that the risk trade is still in play. Given the extraordinary measures being taken fiscally and monetarily it’s no wonder that investors are looking to equities right now. For many companies the amount of cash on their balance sheets may lead to increasing dividends, a trend we’re beginning to see, and may be attractive given the potential for inflation down the road.
Figure 2–10-year Treasury Note
The initial reaction to the dollar strength would have to be deflationary and bearish for stocks. However, the lack of interest in Treasury bonds will push investors moderately concerned about he economy toward equities. We’ll have to watch commodity and other inflation oriented sectors to see how far investors venture out into the risk trade, but for now there appears to be tenuous support for stock prices. As the 10-year Treasury yield approaches 4% it will interesting to see how the markets respond.