Option Investor
Index Wrap

That was yen, this is now

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U.S. Indices followed foreign equity markets lower in today's trade after the Group of Seven finance ministers called for a bias toward more flexible exchange rates.

More flexible exchange rates? One would have to read between the lines of this mixed message, which was obviously slanted toward Japan and China. Japan has spent as much as $100 billion on dollar-based assets (mostly Treasuries) this year to keep the yen weak against the greenback to help Japanese exporters. China, Taiwan and South Korea have also been known to filter their currency exchange proceeds and filter them through the U.S. Treasury market to help their exports to the U.S.

The unanimous G7 statement suggested that Japan would forgo its effort to keep the yen at about 115 to the dollar through massive intervention in exchange markets and that sent some shockwaves through the U.S. Treasury bond market, with Treasuries seeing selling on thought that Japan's recent currency interventions would come to a halt.

The findings and comments that came out of the G7 ignited fireworks in the worlds currency markets and impacted global equity, especially those in Asia. Japan's Nikke-225, which is Japan's equivalent to the Dow Industrials here in the U.S., fell more than 4% in Monday's session as the Japanese yen jumped to a 3-year high against the dollar. South Korea's Seoul Composite fell 4.4%.

The United States led the campaign against the Japanese and Chinese currency manipulation after U.S. manufacturers complained that the overvalued dollar was killing U.S. jobs, especially in the manufacturing sector. Treasury Secretary John Snow has now backed away almost entirely from his predecessors' constant mantra that a "strong dollar is in the interests of the United States."

While Treasury Secretary Snow did say late this afternoon that the Treasury still supports a strong dollar policy, it was thought that Treasury Secretary Snow's comments were directed toward the euro versus dollar relationship.

Gary Noone, a currency analyst at MMS in London summed up some of the G7's statements by saying, " I think the dollar has a lot more downside between now and Christmas," he said. "There will be more emphasis against the Asian currencies and a lot more pressure on the Chinese to revalue. The dollar could be up for a bit of turbulence."

While equity markets were sharply lower in overseas trade, stocks here in the U.S. were not hit quite as hard as prospects for a weaker dollar would still be considered positive for U.S. exports as they compete against foreign produced goods on a global basis. However, stocks did trade lower on concern that a weaker dollar policy coming out of the G7 could send just-recovering economies like that in Japan, which has seen a decade of economic slowing, back into recession on the prospects that a strong dollar hurting Japanese exports to one of its largest trading partners.

Best done in moderation

As we've discussed in prior Index Wraps, the strong/weak dollar can be a double-edged sword, where a weaker dollar can end up cutting both ways. A favorable cut can be found for U.S.-based companies that export goods to foreign markets, where U.S. products become cheaper as the dollar weakens. The sharper or more negative cut, which could cut off the hand that helps feed U.S. exporters is if the competing currency strengthens too fast and creates recession or economic slowing to the market exported to. In Europe, just as a strong dollar may have seen jobs get lost to overseas markets like Asia, European-based multinationals have complained a strong euro has hurt sales for European exporters, forced layoffs in the region, as the greenback has weekend and has put a lid on economic recovery in Europe.

As investors the world over digest this weekends G7 comments, many currency followers feel a gradual adjustment to the G7 findings isn't nearly as alarming as a sharp and prolonged correction in the currency/bond markets would be to those comments.

The rather sharp decline in the dollar, which began early Sunday and continued through Monday's session found U.S. Treasuries under heavy selling pressure in the first half of today's trade, but a slight rebound or ease of selling from the 12:00 PM EST lows when the benchmark 10-year YIELD rose to a session best 4.324%, saw some late session buying stem losses with the 10-year YIELD ($TNX.X) rising a more modest 7.9 basis point to 4.241%. The 10-year Treasury December futures contract (ty03z) fell 14/32, or 0.38% to close near its session high of $112'035.

Of the major equity indices here in the U.S. that traded lower, the NASDAQ-100 Index's (NDX.X) 1.86% decline was modest compared to the Nikkei's 4.24% decline.

Bottom line:

A sharp and rapid decline in the dollar has some economists concerned it may make Treasuries near-term unattractive to foreign investors and have a sharply higher YIELD making for higher rates of consumer interest.

I (Jeff Bailey) think that this summer's rather sharp selling in Treasuries, which many bond market analysts feel was partially exacerbated by mortgage hedges coming off, may now find notable dollar weakness should similar currency hedges come off from Japanese and Chinese buying of Treasuries to create the stronger dollar and weaker yen, which were being put in place by Japan and China to keep their currencies weak versus the dollar.

The biggest threat to equities as I see it would be a continued rise in Treasury yields and weakness in the dollar, which would depict a disinterest in U.S. assets by foreign investors. I would be more inclined to emphasis weakness in the dollar versus the Euro than I would dollar/yen, but the dollar/yen relationship comes into play when we consider the large amount of Asian buying in Treasuries, which has perhaps helped keep YIELDS just as artificially low as Asian currencies versus the dollar.

I'll take a look at both the Dollar Index (dx00y) and 10-year YIELD ($TNX.X) tonight, and will also make a note at to September 2, 2003 time reference when the S&P 500 Index (SPX.X) broke out of its summer range to try and see if there was similarity between the dollar/bond and if we might look for DIVERGENCE to also see weakness, or a loss of strength for equities as depicted by the S&P 500 Index (SPX.X).

Some of today's internals:

Volume levels at both the NYSE and NASDAQ were not overly heavy with the NYSE turning just over 1.24 billion shares, which compares to the past four days of volume of 1.29, 1.31, 1.39 and Friday's 1.37 billion shares. NASDAQ traded just over 1.7 billion shares. While heavy, volume levels did not surpass recent session's volume of 1.75 billion, 1.89 billion, 1.93 billion and 1.82 billion shares traded on Friday.

Short interest builds on DIA and QQQ, but falls for SPY:

Monthly statistics on short interest were released this weekend. The Dow Diamonds (NYSE:DIA) $95.55 -0.95% showed short interest increasing for an eighth-strait month to 23.849 million shares (August 15 = 23.314) as of September 15th, with days to cover growing to 4.37. The S&P Depository Receipts "SPDRs" (AMEX:SPY) $102.55 -1.08% saw short interest decline to 104.245 million shares from its August 15 113.174 million shares short level, marking the first decline in six months. The NASDAQ-100 Tracking Stock (AMEX:QQQ) $33.92 -1.9% showed short interest increasing by 15.841 million shares to 303.549 million as of September 15, its fifth consecutive month of increase and nearly double that found at its April 15 reading of 151.785 shares short. On April 15, the QQQ closed at $26.28.

There is still a good amount of short interest in the tracking stocks and would most likely give the impression that the recent new 52-week highs found in the major indices should have shorts providing support for pullbacks.

Here's a quick look at the Pivot Analysis matrix where we did see WEEKLY Pivots violated to the downside, with the S&P 100 Index (OEX.X) 513.31 -1.4% trading its WEEKLY S1 intra-day.

Pivot Analysis Matrix -

Tonight's Index Wrap will give some focus to any DIVERGENCE between the 10-year YIELD ($TNX.X) and the U.S. Dollar Index (dx00y) 93.99 -1.02%, which continues to trade Monday's session, but is up from the 03:00 PM EST mark, which I used in the DAILY pivot matrix. In PINK I've marked the September Points from Pivot to simply make a general observation of how dollar weakness was being mirrored by a lower 10-year YIELD (buying in Treasuries), where we do see some DIVERGENCE from this general trend today, with obvious reason being this weekend's G7 meeting.

Since one day is not a sufficient time frame to say that dollar weakness and Treasury price weakness (rising yield) will be a negative for equities, I think it best to try and review recent dollar/bond/equity trade direction.

Here's a quick look at the U.S. Dollar Index (dx00y), which shows the dollar having been finding weakness into this weekend's G7 meeting and gapping lower when the dollar began trading early Sunday.

U.S. Dollar Index (dx00y) - Daily Intervals

Currencies as their fluctuations can have great impact on economies that are pegged to their value. While a weaker dollar helps inflate a U.S. economy, the opposite effect can be found for a foreign economy that may be pegged to a stronger euro or yen. The main observation isn't in the dollar itself, but what Treasury YIELDS were doing at the same time. This weekends G7 gathering had central bankers wanting to see Asian countries cease their currency interventions to have their currencies weak against the dollar.

10-year Treasury YIELD ($TNX.X) - Daily Intervals

Both the Dollar Index (dx00y) and Treasury YIELD action ($TNX.X) have been mirroring each other. During this summer's strengthening of the dollar and selling in Treasuries, which had YIELD higher, the broader S&P 500 Index (SPX.X) became rather range-bound. It was until early September that the SPX broke out of its range as the dollar weakened and Treasury YIELDS reversed their rise.

The main concern for equities isn't necessarily a weaker dollar, but concern that foreign investors, namely China and Japan would flush their large Treasury holdings, and have YIELDS rising further.

S&P 500 Index Chart - Daily Interval

The SPX broke out of its summer consolidation period earlier this month, and while that break may not have single-handedly come from renewed weakness in the dollar and strength in Treasuries, which has YIELDS pulling back from the recent highs, it may have helped bolster enthusiasm for equities.

I've marked the SPX's June 17 high, which seemed to begin a summer range where a stronger dollar and weaker Treasury market (higher YIELDS) put a lid on gains. While the SPX has been showing strong gains since early summer, we would now want to monitor from DIVERGENCE in the dollar/bond relationship, where further weakness in the Dollar, which the G7 seems to think is called for as it relates to Asian currencies, might run the risk of a sell-off in Treasuries, which has YIELDS moving higher.

On the above chart, I also pointed to the August 15 close in RED (08/15/03) where short interest on the SPY declined in the recent month (08/15/03 to 09/15/03).

Today's trade saw the broader S&P 500 Bullish % ($BPSPX) see a net loss of 1 stock to a point and figure sell signal as the bullish % slipped to 82.6% from Friday's 82.8%. Still "bull confirmed" status.

The narrower S&P 100 Bullish % ($BPOEX) saw no net change in its bullish % ($BPOEX) and still remains "bull confirmed" status at 87%.

Dow Industrials Chart - Daily Intervals

The Dow's 1.13% decline was modes relative to the Nikkei's performance today. Still, I would keep an eye on the Nikkei's performance near-term as Japan's banks also hold large holdings in Japanese stocks. If Nikkei runs south, Japanese banks could sell Treasuries to make up some of the difference, sell U.S. Treasuries, repatriate their dollar after G7 advised them to stop intervening in currency market to prop up the yen. Dow support should be firm above 9,425 and pullback bull would like to see firming there as stochastics return to oversold.

Today's trade saw no net change in its very narrow Bullish % ($BPINDU) and still stands at "bull confirmed" status and 83.33%. Dow component Caterpillar (NYSE:CAT) $70.47 -1.01% said last quarter that it benefited greatly by a weaker dollar in Europe. Shares of Eastman Kodak (NYSE:EK) $27.95 +0.53% has often complained that its film sales have suffered at the hands of a weaker yen, as its rival competitor Fuji has had better competitive pricing due to weaker yen/strong dollar here in the U.S.

NASDAQ-100 Tracking Stock (AMEX:QQQ) - Daily Intervals

Despite gains in monthly short-interest, the QQQ didn't find as many aggressive bears looking to cover as there were willing sellers at our cloned downward trend. While the past is no guarantee of the future, past breaks to new 52-week highs did find pullback support to these cloned trends. The rising 21-day SMA along with WEEKLY S1 at $33.73 still provides near-term support for bulls, but risk to downside on a break of the 21-day SMA could have QQQ vulnerable to the $32.87-$33.09 area. With Oscillator more negative right now (Stocks turning lower from overbought and MACD wavering and below signal), would want to see QQQ above WEEKLY pivot and back above our cloned downward trend for strength. Aggressive bears will play as they have in the past, with risk being assessed to the highs.

Today's trade saw no net change in the NASDAQ-100 Bullish % ($BPNDX). Still "bear correction" status at 80%.

Jeff Bailey

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