by Kevin Klombies, Senior Analyst, TraderPlanet.com

A number of weeks ago we introduced a topic that revolved around the directions of the trend for the U.S. dollar and the long end of the U.S. Treasury market. To quickly recap… if the dollar and bond market are rising then it makes sense to focus on the financials, consumer defensives, and even a few of the non-commodity consumer cyclicals. If the dollar is rising but the bond market is falling in price then concentrate more on cyclical sectors like tech, telecom, and even the autos and airlines. If the dollar is trending lower but bond prices are rising then move towards gold and if the dollar is lower and bond prices are also trending to the down side then the best sectors will tend to be the commodity cyclicals (i.e. base metals, mining stocks, oil and gas, ag, etc.).

We have argued on occasion that our favored outcome going forward includes both a stronger dollar and a rising bond market so the focal point of much of our work has been on the consumer defensive and health care themes with a wild card lean towards the biotechs.

We are not arguing that bond prices have to go up or even that the equity markets need the bond market to rally to do well. In fact… in recent years the equity markets have tended to do very well when bond prices were trending lower so we start things out today with a comparison between 10-year U.S. Treasury YIELDS and the S&P 500 Index from 1998- 99.

The chart shows that it is absolutely possible for equities to rise in the face of a higher trend for long-term interest rates. This typically happens when the economic growth is fairly ‘tight’ relative to capacity. Following the 1998 Asian crisis and a quick series of cuts in the Fed funds rate the stock market exploded to the upside in lock step with yields. These sorts of reactions tend to go with very sharp but reasonably brief stock market rallies.

The Japanese stock market has been trending inversely to the bond market for years. We could argue that this relationship began back in 1994 or potentially as far back as 1990. The ratio between the Nikkei 225 Index and the S&P 500 Index has tended to mirror the trend for both the long end of the Treasury market as well as Japan’s 10-year (JGB) bond futures.

Our point? Aside from the fact that long-term Treasury prices continue to decline on virtually a daily basis our view is that bonds will resolve higher. The equity markets can rise on both a strong and a weak bond market with the major difference being the kind of sectors that show relative strength.

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Equity/Bond Markets

For some unknown reason we feel compelled to show charts of gold futures even though we really don’t have much interest in the day to day fluctuations of gold prices. Our sense is that this is yet another market that too many people have crowded into and when the deleveraging rotation reaches the gold market prices will decline far lower than most believe possible. We have argued that gold looks better in the mid-500’s than the mid-700’s but in our darker moments we believe it possible for gold to trade sub-300 once again.

However… we aren’t going to lose any sleep if gold prices spike back towards 900 or even move back above 1000. As mentioned in previous issues we simply can not be positive on gold at this time. We have been very positive on gold prices in the past- at much lower levels- and expect to be positive on gold prices in the future but this is not the time nor the place from the stand point of intermarket analysis to like gold.

Our final comment would be… the rising trend for gold prices began back in 2001 when the Swiss franc began to move higher. The recent lows in the franc below .8600 mark the first serious test of the rising trend since mid-2007. If the franc breaks to new lows this week, next month, or even next year… we would expect gold prices to follow.

Many believe that the equity markets turned lower this year or, perhaps, back in 2007 but our point is that the ‘root’ downward pressure began at least as far back as late 2005 or early 2006. In late 2005 European short-term interest rates began to rise as 3-month euribor futures prices declined followed in early 2006 by rising Japanese interest rates.

We mention this because the Bank of Japan may cut interest rates today and next week the ECB is expected to do the same. The downward pressure is shown through the declining ratio between Mitsubishi UFJ (MTU) and the gold etf (GLD). Stronger financials and weaker gold prices would mark the start of a recovery.

Quickly… for some reason crude oil futures are finding major support at 10 times natural gas futures prices. We have no idea why but our long-term point has been that this ratio has to eventually decline below 7:1 before a cycle bottom for crude oil prices will be reached.

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