Watching the bonds

Key News

Quotable

“In my view it is the US who should be agitating for an end to the US dollar as the default reserve currency, because this means that any time a country needs to grow reserves or turbo-charge domestic growth with mercantilist industrial policies, thanks to the flexibility of the US financial system and the foreign desire to accumulate dollars, it is almost always the US tradable goods sector that is forced to adjust. In a similar vein it should be foreigners, especially Asians, and most especially China, that should want to maintain the existing currency system.

“I also suggested to the interviewer that in two or three years no one would be talking about this topic anymore. She was surprised and asked me why. The reason has to do, I think, with the expected evolution of the US current account deficit. For several years the US has been running, as we all know, very large current account deficits.

“This means that the net accumulation of dollars by foreigners (foreign purchases of dollar assets minus American purchases of foreign assets) has been extremely high – just as in the 1960s when the combination of a trade deficit, foreign military spending, and large foreign aid programs created a dollar glut, along with heated arguments about the international role of the dollar. If the US current account deficit remains high, foreigners will continue to be large net acquirers of dollars.

“But if the current account deficit declines quickly, as it has and as I expect it to continue doing for a while longer, the problem of too many dollars being held abroad will disappear – or, more technically, it will simply be the obverse of the change in investment flows into the US. Once the world stops accumulating hundreds of billions of dollars every year through the US current account deficit, the argument over the dollar will fade away and, not coincidentally, a larger portion of foreign reserves, and probably international trade, will naturally be denominated in non-dollar currencies.”

                             Michael Pettis

FX Trading – Watching the bonds

If you’ve been watching the bonds, you likely know they have been in a tight embrace with the US stock market–stocks up in price, bond down in price (up in yield), and vice versa. But to the chagrin of inflationist, bond prices have held up well despite ongoing supply, as demand for said bonds, especially from the US itself and continued support from our friend China.

If you know the bond-stock correlation has been tight, you also probably know the dollar-stock correlation has been tight as well. It’s all pretty clear in the chart below, I think…

This can be viewed another way—through a technical analysis of the stock-bond ratio. That’s exactly the interesting piece of analysis we received yesterday from another wise reader of Currency Currents; I thought you might be interested.

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Dow Jones Industrial Average/T-bond Ratio – Safer to be in bonds again
Guest Commentary by Tony Henfrey

DJIA/TBOND RATIO, safer to be in bonds again
18 August 2009

The short term system has triggered a sell for the ratio (closed yesterday at 76.3) and if it takes out 72.5 support it is likely that the medium term trend will turn negative.

The weekly view of the ratio (medium term) shows that there has been a Fibonacci 38.2% retracement of the July 07-March 09 decline…the decline unfolded in 86
weeks and the recovery high took 22 weeks. So it would not be unusual for the ratio to now turn down.

The daily chart shows that the ratio may have unfolded in an A-B-C correction…certainly it has violated its uptrend from the 67.4 low and if it takes out the uptrend at +-72.5 it would likely mean a sustained period of weakness. The 34 day indicator is declining and daily MESA forecasts a decline until 1 September, a rally to 21 September and then downhill until 25 November.

By Tony Henfrey

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…so, if Mr. Henfrey is correct, and the big drop in the Chinese stock market again last night ushers in some risk aversion to boot, maybe the dollar and bonds can stage a nice little rally. The key word of course is “maybe.”

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