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WEEKLY REVIEW
by Jes Black
Editor & Publisher FX Money Trends
October 3, 2004

Markets behaved more or less as we suspected this past week. An upward revision in Q2 GDP put the stock market in a good mood and acted as a catalyst to our bearish bond bet. The dollar broke down as we forecast and the precious metals rose in conjunction with a breakout in the CRB commodity index.

Bond Focus:
Recall that last week we reissued the chart showing the price spread between the 30 year and 10 year bonds, saying that when it has risen by about 5% above it mean value, interest rates have immediately spiked higher by 50 to 150 basis points. That spread reached a new all time high last week, just before the reversal in bond prices.

Bond prices now appear to have put in a major top, as 10-year yields rose above our cited 4.13% level, and must now overcome the next and final level at 4.3% to indicate a reversal. A move above here would allow us to add to our short bond positions.

We feel pretty confident that this will transpire when you consider that the 10 Year Note prices (continuation contract) broke their 3-1/2 month uptrend line on Thursday. Coming under 111.45 (4.3% yield) would confirm the breakdown and likely lead to a test of the June lows.

Aggressive traders may want to consider going short bonds now or upon a retest of the broken trendline support seen in the chart above. Risk is limited to the previous high at 113.80, or about 2% from current levels.

To recap: Bonds are now heading lower from our cited resistance levels and may accelerate their losses if a replay of the past two bond market declines erupts.

The key to understanding what transpired over the past month in the bond market can be related by the latest earnings announcements of the major money center banks in New York. One major bank saw its profits rise by 30% while the other saw its profits fall. The only difference between the two banks was that one bet long the bond market while the other either bet short or stayed out.

What is instructive about this is that it shows just how powerful the “carry trade” can be when traders with access to cheap funds go long the long bond.

But the flipside to this is that a carry trade eventually must be unwound, resulting in too many players trying to exit at the same time.

Currency Focus:
Recall that last week we took to the sidelines in the US dollar as we felt a near term decline was a high probability event. Interestingly, the dollar broke down from its three-month consolidation pattern right as US yields bottomed and headed higher.

This would appear to go against our “dollar bullish/rising rates scenario,” which has kept us on the correct side of the dollar’s swings all year. But until yields turn above 4.3% there is no way to say for sure (and thus announce it to the FX market) that bonds are ready for another steep decline, thereby pushing yields and the dollar higher as has been the case for the past two years. Instead, the market’s focus is on the possible “soft patch” and the dollar’s technical breakdown across the board is likely to be a larger focus over the next few weeks.

In fact, the decline below 88 carries a definite bearish signal from a technical perspective as that marked previous support and resistance as well as the uptrend line from the February lows and both the 50 and 200 day moving averages. Due to this breakdown we now suspect to see dollar weakness across the board unless and until the USDX can regain this level.

You may also recall that last week we shifted attention to the Australian dollar. Our rational was to be positioned to either benefit from a falling US dollar if US yields failed to rally, or to be hedged against a broad based US dollar rally by being invested in a highly valuable commodity currency.

The other currency that may be headed for trouble is the Japanese yen. EUR/JPY is on the verge of breaking out of its 8-month bullish consolidation pattern. So while we see EUR/JPY as a possible long position in the near future, AUD/JPY may be an even better bet if commodity prices continue to climb, thereby aiding the AUD, a commodity rich currency, and hurting JPY, a commodity poor (especially oil) currency.

Bottom Line:
Last week we said that almost every which way we look at the bond market something yells, “Top.” Bonds appear to have topped. Stocks on the other hand caught a huge bid on Friday, forcing us to reassess the immediate bearish implication as investors remain in “Investor Nirvana.” Our favorite currency for the foreseeable future (probably 3 months) is the Australian dollar.

© 2004 Jes Black
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