Detailed Market Analysis (Mid 02/11) - Part 3

Finally, in order to get a comprehensive picture of the Market's Wave structure, one should understand the behavior of the US Dollar Index and the Treasury bonds. For the past few months, the market has been going up in the face of declining bonds and the US Dollar. If these two assets classes are near a low, then their rise might result in market weakness. 

Treasury (20+ years):

TLT is close proxy of the long term bond market. 10 Year Treasury Bonds started their decline in the week of QE2 was announcement. This turn was discussed on this blog, in "Quantitative Easing and Recent Market Behavior.... Perplexing!!!," on November 13, 2010. Since then 10 Year bonds have declined 8%.

At that point everyone was extremely bullish i.e. there were more than 90% Bond bulls, especially due to the initiation of Quantitative Easing program. However, now we are witnessing a totally opposite picture with only 8% Bond bulls left. Recently, we have also witnessed significant bond market outflows.  

On the other hand, the chart clearly shows that we are nearing the end of this decline, with a clear 5-waves decline pattern. Therefore, one should be very wary of a potential upcoming upturn in the bond market. This turn will provide significant headwinds for future stock market rally.  

Treasury Bonds (20+ years)

US Dollar:

There are two potential for the US Dollar

1- US Dollar Index is carving out a long-term triangle

2- US Dollar Index is about to embark on an impulsive rise.

Both scenarios, in conjunction with extreme pessimism towards US Dollar support a significant rise potential over the next few months. If this scenario does plays out then one should be careful with commodity prices and the stock market. Since rising dollar usually brings about deflationary pressures, it is highly probable that markets will experience some set back.

A situation similar to today's high flying commodity markets prevailed was seen in the Summer of 2008. However, as soon as the US Dollar started rallying in July 2008 the entire financial system came to a complete halt. Within months stocks and commodities fell anywhere from 40%  to 70 %, from top to bottom. 

Conclusion:

One should vigilantly watch the developments in these two markets to get a cue for the upcoming move in the equity market. Since both treasury bonds and the US Dollar are considered to be a safety play against economic and socio-political uncertainty, there completed decline patterns and possible upward reversals might suggest that we are in for a rough ride in the equity markets. 

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