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Here’s a scenario I’ve been thinking about the last week or so:

First, take a look at the monthly USD Index chart below. Notice how the market stalled out below the early 2009 peak. Notice also how wide the Bollinger Bands are. This could be the set up for the market to turn down at least into the middle part of the recent broad range.

Now look at the S&P 500 chart. Here too we’ve seen a recent upside failure. One could point to resistance near 1200 from a low put in during the big decent as well as another from back in 2006 during the rally. The Bollingers are flat to narrowing. If the index cannot hold above about 1040, the odds will be very good for some kind of move back toward 900, or lower.

Then there’s the 10 year Treasury Note yield chart. Here too we’re looking at a recent rejection of higher levels and the risk of a breakdown, if it hasn’t already begun. It’s not hard to imagine the rate dropping below 3% once more in the months to come.

Now the question that comes to my mind is what would be negative for the dollar, negative for stocks, and negative for US interest rates? Those three markets have not moved in tandem of late. It’s generally been stocks going one way and the USD Index and Treasury yields going the other thanks to the risk-on/risk-off nature of the market psychology. If yields are falling, it suggests economic weakness and/or expectations of holding or lower rates by the Fed. If stocks are falling it’s generally about weakness in the economy and/or corporate profits.

So what would cause the dollar to drop at the same time as stocks and Treasury rates?

The number one reason that jumps out at me is a shift away from the flight-to-quality mentality which has bid-up the dollar and a return to more normal trading. That is the type of trading which sees the dollar lower on declining Treasury rates. In other words, the risk I’m seeing in the potential price action is an economic downturn in the US.

For this scenario to develop, however, the dollar needs to continue its retracement off recent highs and stocks and yields both need to carry through with their potential bearish set-ups. It might be a while yet before we see confirmation, if it’s to come, and if any other market goes higher rather than lower it changes things all together.

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results.

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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.

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This entry was posted on Tuesday, June 15th, 2010 at 11:03 am and is filed under Forex Trading, Market Analysis. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.