Risk Assets Likely to Further Correct Before Another Move Higher Commences
Currencies failed to break through technical levels this time around and bond yields are telling us that there's more to go in this short-term correction in risk assets.
So, my work here is designed to focus on the biggest, most liquid markets in the world (currencies and fixed income). I do that so that we can get a truer picture of what's going on with institutional investors globally than can be seen in stocks alone.
Right now, bonds are sending out cautious short-term signals while currencies are backing off after some sharp moves. Once we see targets hit on the downside in yields, we should see a renewed rally in risk assets and a sell-off in safety-oriented assets.
We continue to play the waiting game with the EURUSD.
Apparently with the entire European continent back to work now, we are to be on high alert for more meaningful news flow from "over there." For the last several weeks while the news flow has been slowed due to vacation, the euro / US dollar currency cross (EURUSD) has been working its way higher as part of what I'm feeling is a wave (ii) correction.
Second wave corrections can sometimes re-trace 100% of the preceding first waves, so we must be cognizant of the possibility of that scenario playing out here. However, given the evidence at hand thus far, there's a good chance that we could end up seeing the EURUSD hit the proverbial wall at its 38.2% Fibonacci retracement (of wave (i)) line resistance at 1.25932. Last Thursday, the EURUSD peaked out at the 1.25888 level on an intraday basis. The cross has backed off a bit since then, but that level is still very close by and doesn't give the EURUSD – or the risk assets that seem to be trading in tandem with it – much more room to run.
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The US Dollar Index ($DXY) is once again echoing the potentially cautious message that the EURUSD is sending out. In this case, though, the DXY is approaching its 50% retracement (of wave (i)) line resistance level as it working its way through a wave (ii) correction of its own. That resistance for the DXY comes into play at 81.09 – it hit an intraday low of 81.22 last Thursday and has since bounced a bit. From Tuesday morning's level of around 81.70, a move down to 81.09 doesn't leave a lot of room to the downside for the DXY. As the DXY's (and the euro's) movements have been a clear driver of the directional moves in risk assets, only a little room left before support is hit in the DXY could / should translate to only a little room being left in the rally in stocks.
Of course, there's no rule saying that either the 38.2% retracement level for the EURUSD or the 50% retracement level for the DXY have to hold up. If these technical levels are broken, it will almost certainly spell another leg higher for stocks, crude oil, gold, and other risk assets.
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Treasury yields signaling a bit more short-term weakness followed by another rally in risk assets.
The daily chart of the yield on the 10-year US Treasury Note ($TNX.X) is shown below. As I have been suggesting over the last couple of weeks, a downside correction in rates is underway. This correction (wave b) is occurring after the sharp wave "a" higher that occurred during July and August. My call is for this correction lower to continue to around the 1.49% level and then for another move higher in rates (wave c) to commence. My upside target for wave c will be the 23.6% retracement (of wave iii) level at 1.949%. That level also will correspond almost perfectly with the 100% Fibonacci price projection level for wave c of the "abc" formation that seems to be playing out.
So, what will these moves likely mean for equities? The remainder of the move lower in rates to the wave b target should mean some more short-term weakness for stocks and other risk assets. However, the move from 1.49% to 1.949% in the 10-year Treasury Note Yield (should it occur as I'm laying out here), would almost certainly coincide with a nice move higher in risk asset prices.
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So, we're seeing the potential for some short-term weakness in the EURUSD, strength in the DXY and lower bond yields. That much is clear. What is a bit more in doubt is what will happen after bond yields bottom out. I'm thinking we see a move higher in yields as the EURUSD, stocks, and certain risk commodities rally. That should be coupled with the DXY moving lower. Where I'm not as certain is whether the rally in stocks and the EURUSD will bring about new short-term highs or just a test of resistance again. One thing seems likely, if not completely certain, stocks will have a tough time making new highs if the EURSUD doesn't make it through that 38.2% retracement line resistance at 1.25932.
Before I wrap up, here's a check up on the key European sovereign debt yields:
Not much should be read into the moves in the European sovereign yields over the last week. What happens from today forward is really where the rubber should meet the road in terms of news flow and meaningful movements in the fixed income and equity markets "over there."
That's it for now. Have a great week!
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