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Treasury Yield Relationship to Currencies
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With the Federal Reserve interest-rate hikes and escalating energy prices taxing the American consumer, it is no wonder we were expecting a con traction. Some argued with the longer-term yields on Treasury bonds in verting in relationship to shorter-term maturities. This gave even more reasons to suspect a more-than-moderate slowdown might occur. Based on historical standards, when interest rates on the long end of the yield curve are below those of shorter-term maturities, we have entered into reces sionary periods. The word recession was being tossed about by many lead ing analysts as a result of this reoccurring. As of August 21, 2006 , the yield on the 10-year note was at 4.84, and the yield on the 2-year note was at 4.87. Figure 1.6 plots the yield on the various Treasury maturity issues. As you can see, the yield on the 10-year note dips below that of the 2-year note and creates the inversion.

An investor or a foreign central bank can park money into a short-term instrument and receive close to a 5 percent return without risk. That is one feature that will attract foreign capital flows and help support the dollar. This effect will occur until better opportunities evolve elsewhere. As a forex trader, you want to monitor yields on a global scale or events or re ports that may impact these rates.

Lessons Learned from Energy Prices

We can benefit with the knowledge from where energy prices are, espe cially crude oil. As prices rise, oil-producing countries increase their wealth. However, oil-consuming nations are at a disadvantage, and the increased cost of fuel can contribute to a recession, as occurred in the United States in the 1970s. If you think about it, higher fossil fuel prices actually act like a taxing effect on consumers. However, after a prolonged price appre ciation, to reflect the higher energy costs, producers eventually need to raise prices in their finished goods and services to maintain a decent profit margin and not absorb the burden of higher energy costs. Who pays the price? You and I, the consumer, and that is inflationary. Crude oil prices hit an all-time high close at $78.40 per barrel on July 14, 2006 (see Figure 1.7), due to global demand and fighting in the Middle East . Tensions flared between Israel and Lebanon . Fears arose when many suspected Iran and Syria

were backing Hezbollah with supplies, fears that Israel would take action to stop the weapon shipments. The markets were on edge as that region was deteriorating by the minute. If that was not enough, Iran was threatening to continue with its nuclear program, despite UN resolutions to have them stop enriching uranium. Iran 's Supreme Leader Ayatollah Ali Khamenei was quoted as saying, “ Iran would press ahead with its pursuit of nuclear en ergy,” thus indicating it would not follow requests or directions from the United Nations. President Bush was quoted as saying we are in “challeng ing times” in a speech made on August 21, 2006 . This was in reference to the global war on terrorism. This strongly impacted crude oil prices, as did the geographical location of Iran and the Straits of Hormuz, where oil cargo vessels sail to the Western world.

Imagine how sensitive the area was with reports that Iran was “testing” surface-to-sea missiles. There are two points I want to bring to your atten tion: (1) We want to look at the impact higher energy prices have on the dol lar versus the currency of oil-producing countries, such as Canada and Britain . (2) We can determine from history that with higher energy prices, the United States is susceptible to recessionary pressures, which put fur ther pressure on the dollar.

As a trader, I want access to as much relevant information as possible to give me clues to the overall market conditions so that I can make a more-educated trading decision. If I know that higher crude prices will weigh on economic development, I need to ask myself how can I profit from that situation. Based on a widely accepted business-cycle flow chart, we see business sectors that perform better under certain market condi tions. As we enter a late-stage economic expansion (as I believe we en tered in mid-2006), energy markets make a move, as do basic materials, as building is going like gangbusters. Then as higher interest rates slow con sumer spending and credit costs a little more, we see money moving into safer issues, such as consumer staples and utilities. This occurs as con sumer confidence declines in the economy, and people rein in spending. Technology is weakest during an economic contraction period as capital spending dries up. Figure 1.8 defines the various stages of the business cycle. At the top of the pyramid, when we are in the middle to late expan sion period, we see energy as one of the top money sectors. As the economy slows, demand for fuel declines; people are more cognizant of their spending habits and start conserving.

Now to confirm that we were, in fact, in a period of contraction, we would look to see if these similarities were reflected in the various stock index performances. If we were entering a period of economic contraction the Dow Jones Industrial Average, which represents 30 of the top blue-chip stocks, many of which offer dividends, might outperform the other indexes. We would certainly expect the Dow to outperform the Nasdaq. Let's examine Figure 1.9. This graph shows the year-to-date gain from December 31, 2005 , through August 18, 2006 . The Dow outperformed all the major stock indexes during that seven-and-a-half-month period. Notice the negative return on the Nasdaq? The key word here is negative. That implies that busi nesses, investors, and consumers are not positive on the economic outlook here in the United States . That does not bode well for the U.S. dollar. What we would look for as a clue that the dollar has bottomed would be for a period of economic expansion led by the technology sector. Until we see signs that the economy reenters a new business cycle, the U.S. dollar might just as well remain under pressure.

As we look ahead to the 2008 presidential election, this period may re define an economic expansion. So watch for signs as technology leads the way. This may attract foreign investment flows, and the dollar may bottom at that time. Longer-term and short-term position traders can profit by watching for resurgence in the U.S. economy and confidence in the dollar. Eventually, it will reign supreme again. If the U.S. economy continues to grow, and if inflationary pressures build, then the Fed will probably continue to raise rates. This action will help support the dollar's value.

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