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Interest Rates Rising and the US Dollar Falling? Something's Gotta Give

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This doesn't make much sense following the Fed's tapering announcement.

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The system's insolvent. No one knows what to do next – except repeat the insanity until the next bubble blows. That'll be the one… the big one… the tipping point just like the tulip.
-- Michael Douglas' character Gordon Gekko in Wall Street: Money Never Sleeps

Happy holidays and a safe and prosperous New Year to all! There has not been much in the way of news flow this week, however the trading action has been noteworthy.

I used the quote above from Wall Street: Money Never Sleeps as a wake-up call for readers in my article from earlier this week. In that article, I expressed concern over the fact that rates and the DXY were failing to lift despite the Fed's recent tapering announcement. I put forth several rather sobering reasons why rates and the DXY were acting the way they were. It's an interesting discussion worth having, so please be sure to check out the full article.

The good news is that at the end of this week's trading, only one of the two uncooperative issues – the DXY – was still not playing by the tapering playbook. We saw a short-term divergence between US interest rates (moving higher – appropriately so, given the Fed's tapering announcement) and the US Dollar Index (moving lower inexplicably, given the move in rates). Notably, gold, silver, copper, and crude oil have all been on the rise in reaction to the DXY's sluggishness.

I don't believe this divergence will continue. I feel that either rates will tumble or the DXY will change course and move higher. Based on the chart of Treasury futures which will be profiled in today's report, I now feel the DXY will be the one to give in and fall into line with higher interest rates.
If rates remain buoyant and the DXY turns higher, it will almost certainly spell trouble for gold and silver. However, crude and copper may be more tied to global economic prospects than the movements of the US dollar. If playing the side effects of a rising DXY, I would stick with the bearish bet on precious metals – gold in particular.

All that being said, before making any macro moves, it may be wise to wait for equities to peak out at around 1861 on the S&P (INDEXSP:.INX) futures and for the subsequent correction / consolidation to take place. That will take us past the holiday trading period and will let the various asset classes react appropriately to the expected correction in equities. Be patient!

Now, let's take a look at the key charts involved in this tapering trade.

BONDS

The 10-Year Treasury futures are very bearish technically in the short-term.


Click to enlarge

The chart above shows 10-Year Treasury note prices (not yields). The weak action in prices is a reflection of the recently rising yields in US Treasuries. Today, the yield on the 10-Year T-note is testing 3%, which corresponds with the test of downside support at 122'29.5 we are seeing on the chart above. The breakdown below 123'23 that occurred (see the yellow box) was a break of "correction support" and meant that lower prices were very likely. At this point, a consolidation to the upside in T-note prices is possible (correction lower in rates), but it should be nothing more than a corrective move. I would be using any corrective move to initiate new bearish bets on Treasury prices (via ProShares UltraShort Lehman 20+ Yr ETF (NYSEARCA:TBT) as an example) / bullish bets on interest rates.

CURRENCIES

The US Dollar Index is conspicuous in its bearishness – keeping Gekko's thesis in play.


Click to enlarge

The US Dollar Index (DXY) has still not broken out to the upside despite the Fed's tapering announcement last week. The DXY bulls need the 80.72 level to be conquered on a closing basis to declare victory in the short term. A continued failure to conquer that level will only serve to embolden the bears. However, if a breakout above that resistance occurs at some point, a run to at least 82.26 is very likely.

STOCKS

S&P futures are not yet pricing in a popping of Gekko's bubble – and likely won't for a while.


Click to enlarge

The S&P 500 e-Mini futures contracts have enjoyed an end-of-the-year rally that has eclipsed all resistance levels.

Now, the next projected target on the upside comes in at 1861 (from 1837 Friday afternoon). The "minis" are already overbought, so any test of that resistance would be an excuse for traders to take profits.

I should note that my target for a pullback once resistance is tested comes in at around 1803-1805. At that point I would be buying back into equities in anticipation of yet another move higher toward the next upside target of 1959.

This is the definition of a "buy the dips" chart. Do not be too aggressive in trying to sell short into this kind of bull market.

SUMMING IT ALL UP

So, for now it appears that rates and the DXY may end up trickling higher as they intuitively should, given the commencement of tapering. That should coincide with continued equity strength – short-term pullbacks not withstanding. The big question on everyone's minds – including the skeptics in the trading pits of Chicago as well as the fictional Mr. Gekko – is whether the Fed will be able to retain control of the situation. In other words, can it allow rates to rise a little, but without spiking out of control? The other question has to be, what would the popping of the government debt / deficit bubble look like?. As always, comments / feedback are welcome from Minyanville's highly educated audience!

Make it a great weekend and a great 2014!

Twitter: @seachangereport

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No positions in stocks mentioned.

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