In case you missed it, the beaten-up dollar has been making a comeback this week.

Traders are scratching their heads, trying to figure out if this is a major turn or just another mild correction, including yours truly.

Now, I’ve said before that a major correction in the stock market could save the dollar now. Or as my colleague Ashish said recently, “Wall Street could rescue the buck.”

But besides the stock market, fixed income can also give us a better idea on what’s going to happen with the dollar. More specifically, yields on 10-year Treasury bonds provide powerful clues on the dollar’s direction.

Let me explain….

Inflation Fears = Time for the Fed to “Do Something”

Last week, we finally started to see some inflation expectations in the market. In response, yields on 10-year Treasuries increased dramatically. Remember Treasury yields have to rise to compensate for the loss of your purchasing power caused by inflation.

But higher yields also translate to higher mortgage rates. So when yields rise too much, the Fed gets antsy because higher mortgage rates do not fit into their overall “fix the economy” plan.

Also, with mortgage resets expected to peak only in the first quarter of 2011, the government cannot afford to have higher yields now.

All the big traders in the market know this. So last week, they were all expecting the Fed would step in and do something about the increased inflation fears. Specifically, they were thinking the Fed would have to rescue the dollar or they would risk spiking commodity prices. After all, when the dollar falls, commodities that are priced in dollars rise.

But the Fed didn’t really need to do anything.

Just the fact that traders expected the Fed to verbally intervene in the markets helped prop up the buck. On top of that, there are new concerns about the strong economic recovery. That was enough to rescue the dollar from its freefall. The dollar has in fact been rallying against all commodities since last week.

Don’t Count on the Fed to Help You, Dollar

But next week the Federal Open Market Committee will meet once again. And a lot of traders are still expecting the Fed to change its language to insinuate that rate hikes will come sooner rather than later.

The problem is that the yields are coming down again really fast. In the last couple of days yield fell more than 0.15%. That’s a really strong movement in a short period of time. So the Fed may no longer have the urgency to save the dollar.

With some of the latest economic data, such as consumer confidence and new home sales, surprising to the downside, don’t count on the Fed to change its tune.

After all, investors fear that the equity market won’t be able to move higher without the liquidity that the government is providing. With unemployment on the rise and consumers confidence on decline, if the government doesn’t carry the economy on its shoulder, no one else will.

How to Tell if is the BIG Dollar Rally

So the dollar shouldn’t expect any help from the Fed. The only thing that can save the dollar is the only thing that the Fed is trying to avoid: a sell-off in the stock market.

I’m on the lookout for a collapse in the equity market to confirm if this dollar rally has legs or not. I suggest you do the same.

First of all, I’ve got my eye on a key small cap U.S. equity index that may be indicating a reversal here in stocks. Also, there are three other technical indicators I’m watching (and you should be too) to tell if this dollar rally will continue…

1. Watch for the euro to close below 1.46.
2. Look for the DXY (U.S. dollar index for futures) to cross above 50-day moving average.
3. Keep an eye on the S&P 500. If it crosses below 1030, that could indicate a reversal as well.

Again, stocks are the key to this dollar correction. Watch the breakout of resistance levels in major equity indices for an indication that the dollar will continue to rally.

Best Regards,
Evaldo Albuquerque

Evaldo Albuquerque is one of our head researchers here for World Currency Watch. He specializes in one of the most overlooked sections of the foreign-exchange market, emerging market currencies (a.k.a. “exotic” currencies). To learn more about his currency strategy, click here.