The catalyst for this turnaround? Look no further than Europe and the reemergence of sovereign credit issues once again. Interestingly, these concerns had been well known and widely talked about for months as CDS (credit default swap) spreads for peripheral EU member debt had been widening steadily for several months and, in some cases, actually eclipsed the levels seen during the height of the concerns seen earlier this year. (For those unfamiliar with what exactly a credit default swap is, they are simply insurance-like agreements that protect bond investors from the loss of value that would arise from a downgrade in their bond's rating. For example, if you bought a GE bond rated AAA for $1,000, the price you paid would reflect the high credit worthiness of GE (the higher the rating, the higher the bond's value). However, if the bond was downgraded to AA, the value of the bond would drop to say $900. So if you tried to sell the bond after the downgrade, you would incur a $100 loss simply because the bond's rating moved from AAA to AA. A credit default swap would pay the owner this difference in value, thus protecting their investment. In return for this protection, the CDS seller receives an up-front premium, which means there is a cost to the bond investor for fully protecting their position.) But in the markets' infinite wisdom, today proved to be the day that these concerns decided to manifest themselves and become a real concern for investors. The primary benefactor of this shift in sentiment was, of course, the U.S. Dollar and the corresponding Dollar Index (DXY). For the session, the DXY finished higher by about 1.0% to 77.77. Aside from the scale of today's rally, which was quite impressive in its own right, today's close has pushed the DXY back above its long-term trend line (shown below).
The fact that today's move in the DXY comprises essentially all of this week's candlestick is a true testament to the scale and speed of this shift in investor sentiment. As I tweeted earlier today, there is still plenty of time left in this trading week for the DXY to turn back around, so it's too early to say that today's price action marked a turning point. That said, I have been saying for several weeks now that the DXY is primed for a turnaround on both a fundamental and technical basis. And, more importantly, that there was considerably more risk associated with being short the DXY at this stage than there was holding a long position. To me this is simply another data point that suggests, at the very least, that the U.S. Dollar is in a bottoming process and primed for some sort of relief rally. Whether or not any relief rally materializes into something more is simply too hard to forecast at the present time.
In a somewhat strange turn of events, Treasury bonds saw their early session bids dry up and push yields significantly higher across the curve. The long end was once again a big loser on the day as the 10-year note saw its yield climb a whopping 10.61 basis points to 2.6631% and 30-year bond yields spiked to 4.2524%, up 12.64 basis points. For me, this is a VERY interesting development. If you recall earlier this year when concerns about European sovereign debt first began to materialize, Treasuries saw investors flocking to them for their perceived protection. Clearly today's trading implies that investors' collective perception of safety in Treasury securities may not be as sure a thing as I once thought. To be sure, some of this negativity is a product of the Federal Reserve's announcement of QE2 last week. And country that embarks upon an expansion of their debt load increases the likelihood of insolvency and default. However, for someone earning a $100,000 per year salary, taking out a $15,000 car loan isn't the type of action that meaningfully increases the individual's default risk. It's more likely than if he had no debt, but it's small just the same. However, if that same individual took out a $300,000 home loan, it would be fair to say that the risk of default would have changed dramatically. And with this latest round of monetary stimulus, this is exactly what the Fed is doing. Up until now, the perceived risk of the U.S. Treasury's inability to pay principal and interest in a timely manner had remained mostly unchanged. However, today's significant back up in yield may be the first sign that investors are changing the way they look at Treasuries; from safe haven to another western economy with real default concerns. Again, time will tell whether or not this is truly the case, but as I read the tea leaves, this is the message I'm getting.
Some might say that the inability of Treasury yields to decline, especially in the face of the Fed's actions, points to an elevated investor concern over imminent inflation. These concerns are certainly well founded given the expansion in the monetary base that is looming. Also, the recent pick up in food an energy prices are adding additional fuel to inflationary fire. (For my part, I view most of the food-based inflation as temporary phenomena given the agricultural sector's proven ability to adjust production quickly and efficiently in relative short order.) However, I believe these perceptions are somewhat misplaced at this point in time. With capacity utilization still at record lows, consumer debt levels that continue to shrink, and low rates of lending to small businesses continuing to plague the domestic economy, the velocity of money in the U.S. economy remains low, thus reducing the inflationary impacts of an expanding monetary base. This is one of the reasons why so many have questioned the potential impacts of QE2. Put more simply, if you earn only enough money to pay your bills, put food on the table, and keep a roof over your head, is the bank's willingness to provide you with a loan at a low rate enough of an incentive for you to take on the debt payment and buy stuff? Of course not. You're in no financial position to take such action (though this is exactly what many did during the housing boom years). This is the exact dilemma the Fed finds itself in right now. It's a big gamble and big potential reason why investors may no longer love Treasuries like they did before.
As the title of this post implies, today's trading action made me feel a little better about my outlook for the markets, especially given the shellacking I've taken in my short gold and equity positions. It may end up being the eye of a larger bullish hurricane, but I'll take it just the same. That said, I continue to look to this week as a good indicator of where investors stand on the eventual success or failure of QE2. As of now, it appears the jury is largely split, though moving slowly to the bearish side of the ledger. But, again, one day does not make a trend, so we'll need to see how things pan out to get the final verdict. I remain cautious for the time being.
Until tomorrow.....
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