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Paper Money And Its Promises

04/11/06 02:24:59 PM PST
by David Penn

Long-term charts of the dollar, bonds, crude oil, and gold help set the table for investors and speculators in 2006. Part 1 of two.

One of the benefits of intermarket analysis is that it affords us the opportunity to look at some of the major markets often overlooked in the daily effort to keep up on the latest, greatest stocks. While it is not always the case that a close study of the US dollar, or the 10-year Treasury note, or crude oil and gold futures will make it easier to pick the next big semiconductor or biotechnology stock, it is quite often the case that an understanding of the forces that shape the economy can make it easier for the investor or speculator to evaluate the issues involved in making commitments to stocks, bonds, or even cash.

This intermarket survey will take a multiyear look at the US dollar, the 10-year Treasury note, crude oil, and gold. Using basic technical analysis tools such as trendlines, support and resistance, candlestick analysis, and pattern recognition, I will examine these four markets to provide a set of "if-then" conditions that will be helpful tools with which to understand the context in which shorter-term moves in these markets will take place. The idea is to examine each market individually and then make a comprehensive intermarket analysis that will be useful for investors and speculators going forward into the balance of 2006.

As John J. Murphy wrote in the first edition of his Intermarket Technical Analysis:

Market analysis, when limited to any one market, often leaves the analyst in doubt. Technical analysis can tell an important story about a common stock or a futures contract. More often than not, however, technical readings are more uncertain. It is at those times that a study of a related market may provide critical information as to market direction. When in doubt, look to related markets for clues.

While this discussion will evince more trust in the individual analysis of individual charts than Murphy expresses in this excerpt, it will still be toward an intermarket "whole" that intermarket "parts" are designed to contribute.

But in this, the first half of the discussion, let us begin by getting to know two of our cast of characters the US dollar and the 10-year Treasury note. As the saying goes, how can you know where we're going if you don't know where we've been?

If there was any doubting the fact that it is the preference of the current Presidential administration in Washington, DC, that the dollar be lowered, then consider the behavior of the dollar when it was rumored that US Treasury Secretary John Snow, a "cheerleader for the dollar" even when the home team was rooting against it, might be replaced.

That was how Snow was characterized by a currency strategist at MG Financial in an article by Nick Godt of ("Snow Falling On Greenbacks," March 30, 2006). The thinking apparently is that with Snow out of the way, the administration could pursue a number of dollar-debasing strategies ranging from "encouraging" the Japanese to raise interest rates at a quicker pace, to "pressuring" the Chinese into letting the yuan "float" a move believed to lead to a rise in the value of the yuan versus the dollar. On the rumor, which appeared in the final days of March 2006, the dollar index plunged from nearly 90 cents to below 89 cents intraday.

From a technical viewpoint, whether Snow stays or goes, the big story in the dollar is this: the greenback has been making higher weekly highs and higher weekly lows since bottoming in the winter of 2004 a time when the stock market was peaking. This pattern has held throughout the course of 2005. However, the trendline from the February 2005 lows was recently broken in December 2005, to be specific. A rally over the next few weeks failed to set a new high vis--vis the autumn 2005 high in the greenback. By the way, the stock market was bottoming at the same time that the US dollar was making that late October­early November 2005 high.

So in some ways, the fortunes of the greenback over the next few months seem tied to a resolution of this trendline break. Here, I am most comfortable using Victor Sperandeo's 1-2-3 trend reversal method to help determine if the dollar will fall, taking out the mid-January 2006 lows in the process, or if it will rise to challenge and perhaps take out the late autumn 2005 highs.

Writing about the 1-2-3 trend reversal in his second book, Principles Of Professional Speculation, Sperandeo notes that there are three conditions involved in a true change of trend. The first is that a properly drawn trendline was broken. The second is that the market in question has stopped making "higher highs in an uptrend, or lower lows in a downtrend." The third is that prices must break out above a previous "minor rally high" in a downward market or below a previous minor selloff low in an upward market. By way of summary, Sperandeo adds:

At the point where all three of these events have occurred, there exists the equivalent of a Dow Theory confirmation of a change of trend. Either of the first two conditions alone is evidence of a probable change in trend. Two out of three events increases the probability of a change of trend. And three out of three defines a change of trend.

Figure 1: Continuous US Dollar Index Futures, Weekly. A 1-2-3 trend reversal set-up provides breakout and breakdown levels for the greenback going into the late spring and summer of 2006. A move above 91 would be bullish for the greenback, while a close below 88 would set a lower low and put a bearish tone to the market for dollars.

Looking at the weekly chart in Figure 1, we can see that the first condition has been met: A properly drawn trendline connecting the lowest lows to the highest lows immediately before the highest high was broken just as 2005 was ending and 2006 was beginning. So far, it also appears as if the second condition that Sperandeo noted that the market, if previously uptrending, has stopped making higher highs has also been met. Since the trendline break and the follow-through into early 2006, the bounce from the correction has failed to set a new high. Instead, the market's bounce in the first few weeks of 2006 saw the greenback meet resistance at about the level of the summer 2005 high.

If this remains the case that the greenback is unable to take out the autumn 2005 high then all that needs to happen to "define" a change of trend (as Sperandeo would have it) is for the third condition to be met. This third condition requires the US Dollar Index to take out a previous "minor" selloff low.

Here are two lows worth watching. The first is the post-trendline break low just south of 88, while the second is the last correction low in the previous advance, the low in the late summer of 2005 that saw the greenback index sink to 86. While a close below the 88 level would be bearish for the dollar, it is a close below 86 that would be virtually incontrovertible evidence of a reversal in the dollar's 2005 trend.

If you don't have anything good to say about something, say nothing at all. If this aphorism were a law, then little but white space would suffice to describe the attitude many investors and speculators have had with regard to the bond market in recent years.

Bonds (basis 10-year note continuous futures) peaked early in the summer of 2003 and have been in a fitful bear market ever since. On reaching an A-B-C type correction low in the early summer of 2004, the bond bear market appeared to have ended for a brief period. And when the bond market low failed to take out the 2004 lows early in 2005, those bullish sentiments among bond buyers faint as they might have been were at least temporarily rekindled.

The hopes of bond bulls were dashed, however, when a bounce from a lows-testing correction in the autumn of 2005 led not to higher lows, but to lower lows by the spring of 2006. As such, the bond market is now trading at levels not seen since the spring of 2002.

There are a number of reasons that observers have pointed to in an effort to explain the bear market in bonds since 2003, with inflation fears probably topping the list. After all, why buy a 10-year commitment to 4% returns if the possibility of a 10-year commitment to 4.5% or even 5% returns might be only a few months away? In part, the inflation watch is abetted by concerns about the intentions of the Federal Reserve Board and whether it is willing to continue to raise short-term interest rates in the face of an economy that many believe is already showing signs of slowing down.

It is an interesting set of circumstances: as many have pointed out, while the Fed is increasing short-term rates, monetary policy in the US is still far more accommodative than restrictive. As such, while there is ample fear among stock market investors that the Fed will continue to raise rates until the market breaks (the 2000 scenario), there is also concern that given the fundamentally accommodative nature of monetary policy currently once the Fed signals an end to its rate-raising campaign, all bets are off to the upside in terms of inflation.

This is what many believe gold investors are responding to, as well as many stock market investors who have managed to keep the markets aloft in anticipation of the great "one and done" the sobriquet for the Fed's final rate hike, whenever that arrives. It is also what many believe Treasury yields and would-be bond buyers are responding to. However long the Fed plans to continue to raise rates, it is widely acknowledged that the Fed is nearer the end of the rate-raising program than it is to the beginning. And it is this outlook that has depressed bond prices and set yields on the 10-year note to multimonth highs, with possibly more to come.

The devil may be in the details, but here it is the context that is most telling. While the bond market in the spring of 2006 may be at the same level it was in the spring of 2002, the difference is that in 2002 the bond market was in the late stages of a swoon in rates that began almost eight years ago when 10-year rates were closer to 8% than 4%. Even as late as the spring of 2002, buyers were still gobbling up bonds and would continue to do so for several more months before the bond market topped in 2003.

On the other hand, it is nearly impossible to look at a chart of the yield on the 10-year Treasury note and not see that a fairly solid consolidation has been developing since the yield lows of 2003. This consolidation has a low end of approximately 3.80% and a high end of approximately 4.60%, and it more or less encompasses the range on the 10-year note yield for the past three years until now, that is, with the yield on the 10-year note breaking out to as much as 4.88% in late March 2006.

Figure 2: 10-year Treasury Note Yield Index, Monthly. The consolidation in 10-year T-note yields from mid-2003 through the end of 2005 was breached in the spring of 2006. Given the width of the rectangular consolidation, a minimum upside move to 5.5% is what bond investors and speculators should be prepared for over the next several weeks into the summer and autumn of 2006.

As Figure 2 suggests, if the $Tnx breaks out above 4.6% and holds, there really isn't any meaningful resistance until 5.5%. Interestingly, if we take the width of the 2003-06 consolidation (approximately 0.90) and add that amount to the value at the top of the consolidation (that is, 4.6%), we get a minimum upside projection of 5.5% should the current breakout in the $Tnx hold.

Another pattern-based observation about the monthly chart of the 10-year T-note yield in Figure 2 is that the price action since the 2003 bottom is increasingly reminiscent of an ascending triangle. Although many technicians myself included are more accustomed to and comfortable with ascending triangles in trends (as continuation patterns) rather than ascending triangles at the end of trends (as in bottoms), the fact remains that ascending triangles can function in both capacities as long as the criteria laid out by technicians like Thomas Bulkowski in his book Encyclopedia Of Chart Patterns are met.

The criteria? According to Bulkowski, the triangle shape, a "horizontal top line and up-sloping bottom trend line," and what he calls a "crossing pattern" are among the top three conditions. Of the last factor, Bulkowski notes:

"[P]rices should cross the pattern several times, not walk along one of the trend lines. The pattern should look filled with price, not white space. Cutting off a price turn and calling it a triangle is a common selection error."

Other factors such as declining volume during the formation of the pattern and the frequency of premature breakouts or breakdowns are also noted, though as with the $Tnx shown in Figure 2, volume does not play a role and, assuming the March 2006 breakout holds, this ascending triangle is remarkably bereft of false or premature breakouts.

What labeling this consolidation as an ascending triangle does do, however, is raise the stakes with regard to any potential upside breakout (such as the one indicated by the March move). Whereas the rectangular consolidation provided an upside of 5.5% in a minimum move, the ascending triangle which includes the 2003 lows in a way the rectangular consolidation did not suggests an even higher minimum move to as high as 6.3%. This comes from adding the size of the triangle at its widest point to the value at the top of the triangle (the breakout level).

Figure 3: Continuous US Dollar Index Futures, Monthly. The positive divergence in the MACD histogram as the greenback moves into the lows of late 2004 is an indication that a bottom may have been created. This argument is strengthened by the size of the positive MACD histogram in 2005.


Of the two commodities paper money (US dollar) and paper promises to pay paper money (10-year Treasuries) it is clear that one is at a crossroads and the other has more clearly indicated its next intentions. The crossroads are present in the chart of the dollar (Figure 3). Is the greenback poised to reverse its upward 2005 trend, potentially testing or taking out the lows of 2005 in the process? Or will the greenback add to the gains of 2005 by taking out the autumn 2005 highs highs that are consummate with the greenback highs from the spring of 2004, as well and making a run on the 2003 highs near 100? From a longer-term monthly perspective, it appears as if the dollar is tracing out a head & shoulders bottom beginning in mid-2003. If this proves to be the case, the 2003 highs will certainly be among the first targets for any renewed rally in the greenback.

If the dollar is at the crossroads, it increasingly appears as if the 10-year Treasury note is barreling down the center of the highway. As Figure 2 suggests, yields on the 10-year Treasury bottomed in 2003 and, while moving higher over the next few years, actually did more sideways work between, roughly, 3.75 and 4.75.

This consolidation provides a great deal of potential support at the 4.75 level should rates as they began to do at the end of March 2006 break free from that consolidation and continue to move higher. Higher 10-year rates, it should be remembered, mean lower bond prices insofar as increases in the "price of money" (as perceived through the interest rate) lead to a relative decrease in the demand for money. What this suggests is that over the longer term, an inverted yield curve in which short-term interest rates are higher than long-term interest rates might be harder to maintain, even if the prospects for intermediate-term yield curve inversion remain healthy.

Bringing bonds and cash together, the outlook appears mixed, with a bias toward higher interest rates and, thus, higher values for the US Dollar Index. If the signals from the bond market are accurate, then whatever short-term weakness investors and speculators see in the greenback may more represent an opportunity for accumulation rather than a cause for dollar panic though inasmuch as the economy is perceived to be levered to inflation, any whiff of dollar debasement will likely provide at least a short-term spur to the equities and gold markets.

Keeping an eye on the dollar's resolution of its 1-2-3 trend reversal on the weekly level and another eye on the breakout attempt in 10-year Treasury note yields should be the best way for traders to keep focused on the fate of paper money and its promises in 2006 and, perhaps, beyond.

David Penn may be reached at

Bulkowki, Thomas [2005]. Encyclopedia Of Chart Patterns, 2d ed., John Wiley & Sons.
Murphy, John J. [1991]. Intermarket Technical Analysis, John Wiley & Sons.
Sperandeo, Victor [1994]. Trader Vic II: Principles Of Professional Speculation, John Wiley & Sons.

Current and past articles from Working Money, The Investors' Magazine, can be found at

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine,, and Advantage.

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