The USD traded at a new low versus the EUR and US equities traded at the high for 2009 Tuesday. Despite the decline in the USD and the rally in equity markets the US bond market continues to rise. USD, stocks and bonds do not normally so closely correlated. Investors may need to keep a close eye on the potential for breakdown of this current abnormal correlation between stocks, bonds and the USD. According to the CFTC Commitment of Traders report for the IMM the week ending September 19th spec accounts have increased net short USD positions to the highest level since May of 2008. Corporate insider stock sales have risen sharply which suggests stocks may be overbought. Marketwatch bond market timing newsletters are the most bullish bonds in 8 ½ years. These markets are ripe for a technical correction and the bond market may be the most vulnerable.
The USD rebounded from a one year low Wednesday as a warning from the IMF that the global recession is not yet over injected a bit of a caution to the recent improvement in investor sentiment. Numerous officials including Canada's PM Harper, ECB's Nowotny and Weber expressed concern about the outlook for recovery in Canada and the EU. Harper said the Canadian recovery is fragile, Nowotny suggests that the EU economy will experience an L-shaped recovery and Weber says that the EU recovery would be muted. Despite uncertainty about the potential strength of global recovery many analysts have concluded that the declining USD reflects improving optimism about the global economy and rising risk appetite. As the USD declines, equity and bond markets are rising. Normally at the start of economic recovery bond yields tend to rise in reaction to improving growth and risk of inflation. One explanation why bond yields remain low is the impact of the Fed bond purchase plan and purchase of mortgage-backed securities. The Fed is supporting the bond market and driving yields lower. Another explanation is that it is now cheaper to borrow in USD than JPY. USD is emerging as the preferred funding currency. As the USD weakens it encourages foreign central banks to buy US treasuries with cheaper dollars. Asian central banks also are buying US treasuries to intervene in support of their own currencies.
The decline in US bond yields may not last much longer. The Fed is expected to soon end its purchase of US treasuries and China may reduce its purchase of US bonds. The trade will be looking closely at Wednesday's FOMC policy statement for clues of when the Fed will begin an exit strategy from quantitative ease and begin to reduce its bond purchases. The Fed will let its bond purchase plan expire in October. The Fed will extend its purchase of mortgage backed securities until Q1 2010. In early August China was reported to be selling US treasuries and buying gold. Some analysts attribute this activity as confirmation that China intends to diversify out of some of its US holdings. In early September, Chinese officials indicated that they may reduce some of their US holdings on USD strength. There is an interesting article on MarketWatch which suggests that China's trade surplus will soon swing to deficit. The reason that China's surplus may swing to deficit is because of improving domestic consumption according to Eric Fishwick head of CLSA Asia-Pacific Markets economics research. Improving domestic consumption in China is attributed to recent Chinese government fiscal stimulus plans to boost the domestic economy. China has increased spending to boost growth and import demand may soon outstrip exports. As China's current account shifts to deficit China may purchase a smaller amount of US treasuries and could turn net sellers of US bonds Fishwick says. China is a major buyer of US bonds with holdings of US treasuries estimated at over $2 trillion.
With the US budget deficit expected to total $1.6 trillion this year and forecast to total $9.05 trillion over the next 10 years, funding of the deficit may become a serious problem. Reduced demand from China for US bonds could send bond yields higher as yields will have to rise to attract other buyers. With the price of gold near a record high and US deficits ballooning it should be only a matter of time before US bond yields begin to rise. The nascent global recovery could be at risk if US bond yields begin to rise and governments withdraw fiscal stimulus to soon. As the US budget deficit continues to grow and China's surplus turns to deficit the USD is expected to trade lower. We could be moving closer to a USD crisis and increased risk of a double dip recession.