Saturday, October 9, 2010

MTU Weekend Ed. - Dollar Bottoming and Risk Assets Topping (10/8/10 Close)

Unconventional monetary policies are distorting financial markets at a primary degree or larger. A build-up of excessive systemic risk among risk assets - the all the same market phenomenon - represents policies’ unintended consequences and a major risk to financial markets. Unintended costs arising from independent central banks without adequate direct accountability to their population are likely no longer hypothetical.

Anchoring on the remaining relatively free markets and making inferences on other financial markets should be especially helpful in this environment. The currency market is a leading candidate since its size, liquidity and relative nature help shield itself from manipulation for any prolonged period (better than other markets.)

Hence, we start with a discussion of the U.S. Dollar before moving on to other markets – interest rates, gold, stocks & vix and stocks in terms of gold. An overriding theme appears to be that the U.S. Dollar is in a bottoming phase and risk assets are topping. Should the USD index and Treasury yields proceed to break below their respective 2008 lows, risk assets will likely continue to appreciate until incidents (as a manifestation of systemic risk) prick the bubble.

******USD Index
A fair amount of ambiguity exists in the direction of the USD index (DX), representing a major challenge to near term and long term market timing. The counts in Chart 1 suggest a high likelihood that the 2008 low in DX will hold, but it is debatable whether the 2009 low survives. Please refer to the blue count and the red count.

For the near term, investor sentiment is running very low with respect to the US Dollar. A near term rebound in DX to the 79 area may already be in progress.

Chart 2 offers a squiggle count of the bullish-DX scenario. This week’s low is likely wave [iii] of C of (2) under this interpretation. Wave [v]-down will introduce a slightly lower low once wave [iv]-up rebound completes. This week’s low could be the end of the correction, but it is less probable with respect to the count shown in Chart 2.

******Interest Rates
Regarding the 10Y Treasury yield, the primary count views the relentless rally in bonds as a deep corrective pullback in yields. While the 2010 high is just 0.1bp shy of the 2009 high in $TNX (10Y yield index), Bloomberg shows a higher intraday high for on-the-run 10-year. Thus the interpretation of an impulse wave advance from the 2008 low is a reasonable one (Chart 3). The outlook for higher rates (i.e. discussed in The Bond Mania (8/20/10)) may pan out, even with the threat of QE2.

To be fair, major concerns to the bearish-bond view are
[1] QE driven purchase and investor-dealer front-running. The U.S. Fed has finally become the second largest owner of Treasuries, with pride. QE's damage to the U.S. Dollar and its boost to risk assets as well as the temporary nature of its impact on risk assets are evident in Chart 4.
[2] An already very deep retrace in yield
[3] The proposed wave (C) is disproportionally large with respect to wave (A). On the other hand, the 10Y yield has yet to break away from the base channel if one takes the bullish-bond count (red).

The bearish-bond count can accept a moderate decline below Friday’s low in yields based on intraday squiggles (Chart 5, above), but another decline is not required. A near term sell-off to the 2.5% area looks likely. The bearish count gets rejected if the 10Y yield breaks down to an all-time low.

With possibly one more squiggle high (which is not required), Gold is at either a major top or a short term top (Chart 6 and Chart 7).

The blue count shows gold completing wave (iii) of [iii] with respect to the February 2010 low. A wave (iv) pullback to the 1280-1300 range is in order.

On the other hand, the red count shows a completed advance at multiple degrees - since the February 2010 low, since the 2008 low, as well as since the 1999 low. This count does not assume an extended wave [iii] of 5 as does the blue count. If this scenario plays out, gold can retrace initially to the 950 area and likely to the 650 area or even below without upsetting long term bullish trend.

From a long term perspective, stocks in late August rebounded off the long term trend line connecting the 2007 top and the 2008 wave (2) top. Currently, stocks are at another long term trend line connecting the 2007 top and the April peak (Chart 8). The overhead resistance may prove to be formidable.

The near term picture is no more bullish. The current advance is at channel resistance (Chart 9), at a logical end of its wave structure (Chart 10), and showing weakening technicals. Chart 9 does show an alternative bullish count assuming an advance beyond the April high. Until stocks manage to break above the base channel and hold, this count remains less likely especially when combined with other aspects discussed here. A drop below the August high will meaningfully "eliminate" the bullish count. In either case, a near term pullback is in order which can morph into a meaningful decline.

Regarding the wave structure since the late August low, in hindsight, last week’s high (discussed in A Potential Top (10/1/10) is either the end of wave (iii) (Chart 10, blue) or the first peak of a wave (v) ending diagonal (Chart 10, red).

In either case, this leg of advance is now approaching its very end based on the squiggle count on the final segment in Chart 11 and Chart 12. Incidentally, futures did trace out an initial small degree five wave decline going into the close and in after hours trading (Chart 12).

Not surprisingly, vol has been sold in recent months. We all know what happens when the vol selling is done. Notably, VIX delivered the final leg of a five-month ending diagonal pullback last week (Chart 13). At the same time, the long term wave structure of the VIX is decidedly bullish (Chart 14).

******Stocks in Gold
Finally, Chart 15 shows the levels of the SP500 index (green line) in terms of gold priced in USD (black line). The wave structure of SPX in “real” terms is more text-book style than SPX in nominal dollar terms. The SPX/Gold ratio is now in a decidedly bullish wave [2] advance or a surge to new highs.

One can identify the following exhaustive list of scenarios by reverse engineering to support this bullish outcome.

[1] SPX and Gold are both in a sustained bull market but SPX rises much faster, implying a collapse of USD (which currencies will likely “replace” dollar in this case?)
[4] SPX and Gold both decline, but Gold drops much faster, implying a bull market in USD.
[2] SPX rise and Gold is unchanged or declines.
[3] SPX is unchanged or rises but Gold “collapses”.

Which scenario is your favorite and the most logical?