Montreal, Canada

The U.S. dollar and interest rates are marching sharply higher this month as the market continues to favorably discount a strong economic recovery in 2010. Indeed, the yield on the benchmark U.S. ten-year Treasury has leapt from 3.20% on November 30 to 3.72% this morning. The more interest rate sensitive 30-year Treasury bond has seen its yield climb from 4.20% to 4.60%. By all accounts bonds are suffering a major drubbing this month.

After plunging against most currencies since March, the dollar has reversed sharply since the beginning of the month; despite all the hoopla about a tanking American currency this year the greenback is down just 2% versus the EUR in 2009. The yen is also declining as Japanese authorities verbally “talk down” the currency and pump additional liquidity into the bank system to flush-out deflation. The dollar is up 1% vis-à-vis the yen in 2009.

The U.S. Dollar Index, a basket of six major currencies against the dollar, has violently retraced its losses over the last four months and sits just south of its 200-day moving average. It would be construed as bullish price action if the index can break through top-end resistance levels.

The tide in favor of the dollar has been so sudden and powerful that the Power Shares DB US Dollar Index Bullish Fund (UUP) is seeking to issue 240 million new shares because of overwhelming demand from investors. If everyone was bearish on the dollar on December 1 then many participants have changed course in late December amid thin global trading, which can exaggerate market action.
The EUR, the second most liquid currency in the world since 1999, has now plunged 4.9% this month against the dollar and is almost trading where it began the year.

Over the last ten years the EUR has gained a cumulative 43% versus the dollar. Other strong currencies like the Norwegian krone have rallied 27%; the Swiss franc has gained 34%. The Japanese yen has gained 10.4% since 1999.

Over the same period, gold has surged a cumulative 280%. Oil prices have rocketed 187%.

So are bonds a “sell” and the dollar a “buy?”

The markets might be at the cusp of repeating what occurred in 2005 when the dollar reversed course following three years of big losses against foreign currencies. The Fed had already started to hike rates in 2004 from very low levels – similarly to right now. The difference between 2005 and 2009 is that the economy is heavily fractured by a gaping hole in bank credit, mortgage securitization, rising unemployment and a bear market still unraveling in residential and commercial real estate. The economy is in far worse shape now.

Another important distinction between 2005 and 2009 is the Fed’s monetary policy direction. By 2005 the Fed had already raised interest rates; it is not hiking rates now.

Judging by historical recoveries after a deep recession, the economy has tended to recover quite forcefully. This was the case in 1992-93 and in 1983-84. Investors are starting to wager that 2010 will result in a big year for GDP and along with that forecast a higher dollar and higher rates.

The market has started to discount a high possibility of a Fed rate hike in June 2010 and traders are dumping Treasury bonds in anticipation of this move. And the dollar is responding. Traders point to the steeping yield-curve or the difference between 2-year and 10-year Treasury bond yields – now at its highest spread in years. Historically, a large spread has resulted in good returns for stock investors.

Though I remain bearish on Treasury bonds longer term because of America’s ruinous finances and higher deficit-servicing costs demanded from creditors at some point, the economy is still mired in a deflationary glut of excess goods and significant industrial slack or excess capacity. It’s truly hard to envision a bold recovery in the absence of organic consumption, weak loan growth at banks and broad-based revenue declines at small businesses.

The market, not the Fed, is taking interest rates higher. If it continues, the Fed will be forced to act and raise the Federal Funds rate. Yet I think we’re seeing a replay of the April to July price action in Treasury bonds earlier this year, which ultimately resulted in a rally for bonds.

The great post-1981 bond bull market is not far from the cliff. We are certainly closer to the edge than at any period since 1980. But I’m still wagering that bond yields will witness another rally over the next several months as a severe global correction unfolds in risk-based assets causing a growth panic and taking government bond yields down sharply as fears of a double-dip recession begin to surface by the second half of 2010.

Until then, T-bond yields above 4% or even 4.5% over the next few months look attractive in an environment of renewed “bubbles,” which might get pricked if long-term rates run too far to the upside.