Rising Yields Cement Dollar's New Highs

Positive developments yesterday (Thursday) sent stocks and the USD higher. While stocks gave up their gains during the last hour of trading, the dollar remained strong. The greenback gained against all its major counterparts, including the commodity currencies, aided by rising Treasury yields. Here's a quick recap of yesterday's news:

1. Unemployment numbers came in slightly better than expected.
2. Strong earnings/guidance from Best Buy and Qualcomm.
3. Citi gained on news suggesting the Treasury will unveil a plan to sell its stake in the bank.
4. Bernanke gave the market another fix of its favorite drug - commitment to keeping easy, cheap money flowing.
5. France, Germany find common grounds for Greece assistance package involving the IMF (but euro makes new lows)

Perhaps the most important development is the sharp rise in 10yr Treasuries which soared after a less than stellar demand for the notes during recent auctions. Would be buyers are already bloated with US government debt and concerns over sovereign debt do not make T notes any more appetizing. Add the potential of inflation to the mix and you have a market demanding higher yields. Higher yields on Treasuries may entice new buying which could keep the yields in check. However, if buyers remain reluctant and demand even higher yields, the Fed may be forced to raise rates sooner than later. Any way, this scenario is largely bullish for the dollar but may or may not be bullish for stocks and commodities (for example, premature rate hikes may hinder the recovery and therefore be negative for stocks and commodities. Likewise, rising yields may push mortgage rates up. Couple that with the Fed ending its MBS purchase program and the eventual demise of the home buyers tax credit - and you might have a recipe for double-dip in housing).

 The potential Greece rescue deal continues to expose deep divides within the EU. It's getting pretty clear at this point that the clock is ticking and something must be done to prevent contagion. After all, the EU cannot afford to let Greece go down the path of Lehman Bros. Therefore, it is safe to assume that under pressure, EU leaders will announce a detailed deal within the next 48 hours. Depending on its conditions, the deal may provide a short relief to the euro but any rally is likely to fade quickly. Greek/German spread have actually come down since late January as the euro continued its precipitous decline. So a fix for Greece may not be a cure for the euro. So much of Europe's destiny is riding on perception. There will be buyers for Greek (Italian, Portuguese, Spanish) debt. The question is, at what cost? If risk perception is high, the cost of borrowing will be high - perhaps high enough to actually drive some of these sovereign nations to the brink.

As noted in previous post, 1175 was seen as the next resistance for the S&P and, indeed, the broad market index was unable to sustain this level. It is important to mention that this was more of a "psychological" level rather than a purely technical resistance/supply zone. The S&P finished the day with a very bearish candle formation, suggesting more downside may follow. After a nearly two month wild rally, and a rising VIX we should not be surprised to see a 1%~2% pullback to the 1150-1130 area. Falling stocks should weigh on commodities and commodity currencies and we may continue to see the Aussie and loonie lose more ground to the almighty (for now) dollar. AUDUSD chart indicates downside risk: