Trading the Parabolic Dollar

The mighty US dollar has been red-hot in March, rocketing higher on the incredible divergence of major central-bank policies.  While the Federal Reserve?s first rate-hike cycle in 9 years looms, the European Central Bank has started aggressively monetizing sovereign debt for the first time ever.  The resulting yield differential has catapulted the dollar parabolic, portending a major reversal and fantastic trading opportunity.

Currency trading is the biggest financial market in the world, with trillions of dollars changing hands every day.  Yet since major currency price levels generally meander slowly, this massive market lurks beneath the surface with scant limelight.  But this month the soaring US dollar and plummeting euro have utterly dominated mainstream financial news.  These warring currencies? huge price moves have been epic.

The dollar and euro are opposite sides of the same coin.  When one rallies the other necessarily falls, and vice versa.  The flagship metric for tracking the US dollar?s price levels is the venerable US Dollar Index, which was launched in early 1973.  It measures the dollar against a basket of six currencies.  And since the euro?s birth in early 1999, it has commanded an overshadowing 57.6% weighting in this benchmark!

When traders are watching the dollar, they?re usually following this USDX which the euro dominates mechanically.  And indeed the recent dollar parabola has been fueled by an utter collapse in the euro.  As of the middle of this week, it had plummeted 12.8% year-to-date!  For the major currency markets that usually move with all the haste of a glacier, this was epic.  It fueled the USDX?s huge 10.5% year-to-date rally.

These extreme moves have left the long-dollar-short-euro trade exceedingly popular today.  Traders are convinced the US dollar is going to keep on surging as the euro grinds inexorably lower.  Fundamental yield differentials support this dollar-bullish thesis.  As the Fed finally starts to hike rates again, and the ECB?s new sovereign quantitative-easing campaign slashes European rates, capital will flock to the US dollar.

This dynamic is already pronounced.  Benchmark US 10-year Treasuries are now yielding about 2.1%.  While super-low historically, this is still vastly higher than prevailing European yields.  10-year sovereign bonds from Germany, France, Italy, and Spain are merely yielding around 0.2%, 0.5%, 1.1%, and 1.2%!  So it certainly makes sense for global investors to seek out the superior returns now available in dollar bonds.

But what started as a sound fundamental thesis has mushroomed into full-on dollar euphoria.  Around the world, speculators have never had greater dollar-long positions.  These record longs reveal a wildly-overcrowded trade.  Pretty much everyone believes the dollar is going to keep on rallying indefinitely at the euro?s expense.  Such universal bullishness is a warning of excessive greed, a critical sign of a major topping.

And if the euphoric dollar is indeed topping after one of its biggest and fastest rallies ever, then traders have an amazing opportunity to bet on its imminent reversal.  Before we dig into ways to trade the dollar, this chart reveals just how extreme its recent parabolic surge has been.  The USDX has not only rallied massively in recent months, but has rocketed vertically.  Such blowoffs are classic signs of topping markets.

As of the middle of this week, the US Dollar Index had blasted 26.1% higher in just 10.2 months!  This would be a major move even in stock markets, but in the usually-slowly-meandering currency markets it is enormous beyond belief.  Since late last June, the USDX has soared 25.1% higher in just 8.4 months.  This is the second biggest and fastest rally this flagship index has ever witnessed, truly incredible.

And that?s saying a lot, as the USDX is a whopping 42 years old!  From the dollar?s sharp rallies of the early 1970s, to its gargantuan bull market in the early 1980s, to its very strong late-1990s bull, there has only been one bigger and faster rally than today?s.  And that happened back in late 2008 during that once-in-a-lifetime stock-market panic, the first one seen in 101 years.  Most alive today will never see greater fear.

As the global stock markets plummeted that dark autumn, and dragged down other asset classes into the abyss with them, global investors desperately fled to the safe-haven US dollar.  So it skyrocketed 22.6% higher in just 4.2 months, in its biggest and fastest rally on record.  That was part of a larger 24.9% rally that unfolded over 10.8 months, which happens to be eerily similar to today?s 26.1% rally across 10.2 months.

The common thread tying together history?s biggest and fastest USDX rallies is extreme emotion.  Back in that terrifying stock panic, epic fear frightened traders into buying dollars.  Since last summer, it has been epic greed seducing traders into buying dollars.  The problem is neither emotional extreme is even remotely sustainable.  Prices surging too far too fast suck in too much future buying, growing terminally overbought.

One of the best ways to measure overboughtness is by looking at a price relative to the baseline of its own 200-day moving average.  Back at the USDX?s initial stock-panic peak in November 2008, it stretched to 15.8% above its 200dma.  Such wildly-overbought levels were not seen again until this week, when the USDX hit 15.3% over!  For reference, in most of the post-panic era the USDX at merely 5% over was overbought.

Vertical parabolic blowoffs are the result of too many traders pouring too much capital in.  The only time that happens is when they become too overwhelmingly bullish as a herd, fomenting a mania.  But such a blistering pace of capital inflows can?t be maintained, as the bullish buyers soon exhaust themselves.  And once that happens, only sellers remain and the vertical price soon plummets symmetrically back down.

That inevitable consequence of parabolic dollar surges is readily evident in this chart.  The only other USDX rallies in modern history comparable to today?s were that 2008-2009 stock-panic one and its aftershock in 2010.  Just as popular bullishness crested and euphoria reigned, these earlier massive rallies rolled over sharply.  After soaring 24.9% in 10.8 months and 19.2% in 6.4 months, the USDX collapsed.

Then the dollar?s post-parabola corrections dragged the USDX back near its original starting points.  This flagship index plunged by 16.7% in 8.6 months and 17.6% in 10.7 months.  Sharp corrections inevitably follow massive and sharp rallies fueled by extreme greed.  And today?s parabolic surge sure isn?t likely to prove any different.  The bullish dollar traders argue otherwise fundamentally, but that?s nothing new either.

When greed and euphoria grip any market, traders always attempt to rationalize away those price levels as being righteous and fundamentally-justified.  And these arguments always sound logical at the time.  Back near the early-2009 and mid-2010 peaks, there was also a universal belief that the dollar was destined to keep on climbing because the euro was doomed to plunge below parity with the dollar.  But it didn?t happen.

Traders as a herd get caught up in the hype at market extremes, expecting the overbought trend to keep on running indefinitely.  But once enough greed and euphoria exist to catapult a price parabolic, the move is already over despite all the cheerleading.  And if you?ve been watching CNBC this week, you know the universal calls for the US dollar to continue surging another 10% to 20% higher from here are deafening.

Since the last two parabolic USDX surges ended in sharp corrections averaging a tight 17.2% decline over 9.7 months, that is as good of estimate as any for the coming US dollar downside.  But the next inevitable USDX correction could easily exceed 17%.  This week the USDX hit an incredible 11.9-year high.  That makes this latest peak even more extreme than the ones seen during and after 2008?s stock panic!

Back then in April 2003, US 10-year Treasuries were yielding around 4.0%.  And with the euro worth about $1.07, it wasn?t much different from this week?s $1.05.  Back then euro-to-zero calls abounded too, and majority consensus was that the Eurozone was doomed.  Traders figured this infighting confederation of disparate nations couldn?t hold together.  But they were dead wrong, the euro powered higher for years after.

Paper currencies are ultimately just an abstraction, an accounting fiction created by governments to facilitate economic transactions.  And with the Eurozone?s gross domestic product estimated at $18.5t in 2014, it surpasses the United States? $17.7t to be the largest economy on Earth!  The euro is used by nearly 335m Europeans, and they?re going to keep working hard and producing regardless of euro price levels.

Wracked by terrible wars and inflation last century, the European people and especially their leaders in government desperately want and need the economic and political union of Europe to last.  And with its massive underlying economy still chugging along, and about to get a major boost from exports due to today?s super-low euro prices, economic news is going to gradually improve.  That will shift sentiment.

And despite the Fed?s coming rate hikes, and the ECB?s new sovereign-bond monetizing, this wildly-overcrowded long-dollar-short-euro trade will start to unwind.  It was just too big and fast, signaling too much emotion, to be sustainable.  The extremely overbought US dollar is due for an imminent major correction, while the extremely oversold euro on the other side of that currency coin is due to rebound dramatically.

American investors and speculators can trade this coming mean reversion through ETFs.  The simplest way is with a euro-long ETF, and the leading one is the CurrencyShares Euro Trust which trades as FXE.  If the USDX corrects on the order of 17% in line with historical averages, the euro will probably rally by at least 20% in a timeline around 10 months.  Alternatively, US dollar ETFs can be shorted.

The most popular one is PowerShares DB US Dollar Index Bullish Fund which trades under the symbol UUP.  It is unleveraged, and seeks to match the USDX?s performance.  Speculators can directly short it to play the coming US dollar correction.  The main problem with FXE and UUP is they only track the euro and dollar, they don?t leverage their moves.  Speculators can deploy FXE calls and UUP puts to amplify these moves.

There are also a handful of leveraged ETFs that track the euro and USDX.  While they are great for day traders, leveraged ETFs are exceedingly risky for longer-term trades like this dollar-euro mean-reversion one that will likely take the better part of a year.  The problem is when prices move against a leveraged-ETF bet, they suffer mathematical slippage.  Losses in countertrend moves erode away the primary-trend gains.

But provocatively investors and speculators can gain low-risk leveraged exposure to a dollar correction through the world?s oldest major currency, gold.  Gold tends to move inversely to the US dollar, as the dollar?s price is a major motivator for the American futures speculators whose trading utterly dominates short-term gold-price action.  This last chart superimposes the USDX on gold, showing its great potential.

Once again the USDX?s last major corrections following parabolic blowoff tops happened in 2009 and 2010-2011.  During those 8.6-month and 10.6-month spans where the USDX dropped by 16.7% and 17.6%, gold rallied 29.1% and 25.8% higher!  This offered inverse USDX leverage of 1.7x and 1.5x with no mathematical-slippage risk at all, trouncing all those dangerous leveraged currency ETFs at their own game.

Unlike the US dollar and euro which are paper currencies backed by nothing but faith in their issuing central banks, both of which print money like mad, gold has great intrinsic value universally recognized throughout world history.  And though gold is as despised now as the US dollar is adored, its fortunes are just as overdue to reverse dramatically.  And the parabolic USDX itself rolling over will be a key catalyst.

Since gold is the ultimate currency, it usually has an inverse correlation to the US dollar.  So once that dollar euphoria breaks and the USDX starts falling, investors and futures speculators around the world are going to start migrating back into gold.  The latent interest for this metal remains robust, despite its low price levels.  There was still enough gold buying to keep it resilient even in the recent near-record USDX rally.

Since late last June as the USDX rocketed 25.1% higher, gold only fell 13.1%.  And year-to-date as the USDX shot parabolic with its stunning 10.5% gain, gold only drifted 2.4% lower!  This extraordinary resiliency in the face of howling dollar headwinds reveals plenty of investment gold buying even with this metal remaining deeply out of favor.  Once the dollar decisively turns south, that buying will really intensify.

Interestingly this strong dollar will provide a secondary boost to gold investment demand as well.  About half of the sales of the 500 elite American companies that comprise the flagship S&P 500 stock index come from overseas.  So the first quarter of 2015?s soaring dollar is going to wreak havoc on their overall earnings.  Many companies have already warned about this dollar strength, with many more coming.

The soaring dollar will cut significantly into first-quarter profits, which is a major problem with the US stock markets already challenging bubble valuation levels on a trailing-twelve-month basis.  Any impact on corporate earnings from the strong dollar will leave today?s expensive stock markets even more overvalued.  And that could finally spark the long-overdue major correction.  Alternative investments thrive when stocks fall.

And gold leads this crucial diversifying category.  Stock traders can easily play the coming USDX correction in the world?s flagship gold ETF, SPDR Gold Shares which trade as GLD.  Since GLD mirrors the gold price, it too is highly likely to inversely leverage the coming major US dollar downside.  And again unlike those dangerous leveraged currency ETFs, there is no risk of slippage for longer-term GLD trades.

Speculators and investors alike need to prepare for the unwinding of the recent near-record US dollar rally, as the implications of a major dollar correction are broad.  Only a handful of contrarians today are warning about the coming dollar correction, including us at Zeal.  We?ve long studied the markets to buy low when everyone is scared, then later sell high when everyone is greedy.  And the USDX exemplifies the latter today.

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The bottom line is the parabolic US dollar is caught up in a popular mania of universal bullishness.  After just enjoying its second biggest and fastest rally on record, the USDX is the most overbought it has been since 2008?s once-in-a-lifetime stock panic.  After all past extreme parabolic surges, the USDX has suffered major corrections that erase most of their gains.  Odds are a similar reversal is imminent today.

Trading the coming dollar correction is pretty easy.  Investors and speculators can short USDX ETFs or buy euro ETFs, as the battered euro will necessarily surge as the dollar rolls over.  While the various leveraged currency ETFs are very problematic for longer-term trades, the oldest world currency gold will nicely leverage the dollar?s downside into big gains.  And gold exposure can be easily obtained with gold ETFs.