Greenback Poised to Knock Over the Dominoes

 | Feb 06, 2013 | 5:00 PM EST
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Before we can attempt to predict the direction of the stock or bond markets, it is imperative we look at intermarket relationships for guidance. Correlations, whether positive or negative, aren't always constant, but they are prevalent enough to justify their use as an analytical tool. That said, traders must keep cognizant of the fact that market moves result from human emotions. As a result, the strength of any particular intermarket relationship will depend on the mindset of the market, as we all know this is in constant flux.

One correlation on our radar is the U.S. dollar vs. risk assets. In general, a stronger greenback works against asset prices simply because it lowers foreign demand for domestic products. In fact, when we measure the correlation between the dollar index futures contract and the S&P 500 futures over the last 180 trading days, the correlation coefficient is a negative 84. This suggests these two markets have moved in the opposite direction well over 80% of the time.

Accordingly, it isn't surprising that the 30-year U.S. Treasury bond futures contract has traded positively with the dollar index about 70% of the time. This is useful information, because correlated markets don't always immediately move together. In other words, it opens the door for speculators to identify markets that might be trading contrary to their tendency, and for these traders to potentially benefit as the relationship presumably reverts back to the norm.  

If we take a quick look at the chart of the S&P, the Treasuries and the dollar-index futures contracts, we see that the greenback could be leading the way toward a reversal. While stocks and bonds are still respectively trolling highs and lows, the dollar has quietly drifted off of long-term support and is moving toward what might be an upside breakout. If you are unfamiliar with the dollar index futures contract, which trades on the ICE exchange, the index measures the dollar against a basket of other major currencies. Accordingly, it's often deemed the benchmark valuation of the U.S. currency.

In our opinion, the dollar index stands a good chance at breaking through its technical barrier near 80.30 to 80.50. If so, it could be destined for a quick short-covering rush to put its value into the mid-to-high-81 area.

Dollar Index -- Daily

Such a move would likely flare up the aforementioned intermarket relationships, thus triggering a correction in the equity market. That, in turn, would support a flight-to-quality bid for bond prices. In addition, we'll likely see short-run suffering among risk assets such as crude oil -- and possibly agricultural commodities such as corn and soybeans -- amid the currency revaluation.

Oil -- Weekly

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