In recent months,
the US dollar has been surging higher. This impressive strength is a
radical change from last year’s relentless grind lower. Across
the globe, the majority of analysts expect this run higher to persist for a
variety of reasons. This prospect is troubling traders of commodities
and commodities stocks.
When the dollar
strengthens, the prices of commodities denominated in it naturally tend to
retreat. It takes fewer stronger dollars to buy a given unit of
anything than weaker dollars. This inverse relationship is especially
evident in the commodities investors and speculators love, like gold, oil,
and copper. So for the commodities realm, the likely future trajectory
of the US dollar is very important to consider.
With consensus
for the US dollar very bullish today, I’m going to offer a contrarian
perspective. Rather than being the start of a new cyclical bull,
technically this dollar surge merely looks like a garden-variety bear-market
rally within its secular bear. And provocatively, given
bear-to-date precedent this particular rally looks mature. Odds are
today’s dollar rally is either already over or soon will be.
I built several
charts this week to flesh out this thesis, using the popular US Dollar Index
to represent the US dollar. This USDX, born in the early 1970s,
measures the US dollar against a trade-weighted basket of major foreign
currencies. This geometrically-averaged index is dominated by the euro,
at nearly 58% of its weight. The Japanese yen and British pound are the
next largest components at about 14% and 12%. Just as the S&P 500
measures broader stock-market progress, the USDX measures the US
dollar’s.
Since late
November, the USDX has surged 8.3% higher. Compared to the downside
trading action over this past year, this dollar rally is totally
unique. So naturally it is leading to a bullish outlook on the US
dollar. Technical action creates sentiment, traders grow excited and
positive when prices rise quickly but worried and pessimistic when prices
fall quickly. And technically it is easy to see why bullishness reigns.
For most of last
year, the USDX ground relentlessly lower with nary a meaningful rally.
Despite rallying US stock markets and gradually improving economic prospects
in 2009 as the stock panic faded into memory, the dollar couldn’t catch
a bid. After watching this currency slide all year, by November traders
were growing exceptionally bearish. Bearish analysis was as dominant
then as bullish analysis is today.
But then in early
December, the USDX rocketed higher on a big positive surprise (119k fewer
jobs lost than expected) in the monthly employment report. That
day’s massive 1.4% surge drove the USDX above its downtrend’s
resistance and its 50-day moving average. This was the best technical
news the dollar had had in 6 months, so technically-oriented futures traders
started buying aggressively. They drove a major upside breakout which
enticed in even more buyers and the dollar was off to the races.
While this
powerful dollar rally soon stalled out in late December, it started surging
again a few weeks later on general-stock-market selling. During the
stock panic, and to a lesser degree since, the USDX had an incredibly-strong
inverse correlation with the S&P 500 (SPX). You can see a stunning
chart of this in an essay I
wrote in August. And interestingly, the March USDX interim high shown
above happened on the very same day the SPX bottomed. When
stocks are weak, flight capital floods into dollars.
This rekindled
panic trade sparked by the nascent SPX pullback led
the USDX to surge again in late January. And this second rally was very
important technically as well since it drove the USDX above its critical
200-day moving average. These 200dmas are high-probability resistance
points in bears, technical zones where bear rallies usually fail. So
with the USDX back above its key 200dma, does this mean the dollar is
entering a new cyclical-bull phase? Most traders today assume so.
And if this short-term
chart is all one considers, that interpretation is certainly
understandable. But in investing and speculation, perspective is
absolutely crucial. If you want to understand short-term tradable
trends, you first have to consider how they fit into the long-term
context. And provocatively if you zoom out to the USDX’s broader
secular bear, the dollar’s recent rally looks a heck of a lot less
impressive.
The US Dollar
Index actually topped way
back in July 2001, an eternity ago in trader-time. Over the intervening
years between then and its all-time low in
April 2008 before the stock panic ignited massive dollar buying, this index
plunged by a jaw-dropping 41.0%! Yes fellow Americans, our great and
glorious currency managed to hemorrhage nearly half of its
international purchasing power in just 7 years! Ouch.
The shaded area
in the lower right of this chart highlights the myopic short-term perspective
the previous chart offered. Obviously the USDX’s latest rally
looks far less impressive in this broader context. Unfortunately most
analysts and traders today, who can hardly be bothered to consider any price
action beyond the last few months, lack this critical perspective. It
sheds a whole new light on the USDX’s newfound strength.
Every major bear
rally the dollar has experienced in its entire secular bear is highlighted
above. And there have been plenty of them. The recent 8.3% surge
we’ve seen over 49 trading days (10 weeks) is not exceptional compared
to previous bear rallies. In early 2004 for example, the USDX very
similarly blasted 8.2% higher in 61 days. Back then it also forged
above its 200dma, yet that certainly didn’t kill its bear.
In fact, in terms
of “normal” bear rallies, today’s specimen has advanced
about as far as precedent suggests it is likely to. The majority of
bear rallies see USDX gains around 4%, while the larger 7% to 8% range is
slightly less common. Remember that the purpose of bear rallies is to
rebalance sentiment, to bleed off the excessive fear that prevails at their
preceding interim lows. And so far in this secular bear, fast 4% to 8%
surges have easily accomplished this mission.
But every few
years or so, there is an “exceptional” bear rally. The first
one unfolded in 2005, when the USDX gradually climbed 14.6% higher over 223
trading days (almost 11 months). Interestingly despite this
mid-secular-bear renaissance of global dollar demand, commodities fared
well. Over this very span, the Continuous
Commodity Index (CCI) rose 16.7%, gold rose 9.3%,
and oil soared 33.2%. This is important because many traders assume a
massive dollar rally guarantees a commodities selloff, but this isn’t
necessarily the case. Over longer periods of time, commodities move on
their own fundamentals.
The second
exceptional bear rally erupted during 2008’s stock panic, when the
flight capital fleeing plummeting stocks deluged into the dollar so fast that
it drove the USDX’s biggest and fastest rally ever witnessed.
Never before had the USDX skyrocketed 22.6% higher in just over 4
months! It was amazing, and crushed
commodities since it happened so fast. But
this was a once-in-a-lifetime event, the first true stock panic since 1907.
You can’t weight dollar precedent too heavily based on a 101-year
anomaly.
The more years I
spend studying the markets, the more I respect subtle patterns that few
recognize. That stock-panic-driven USDX rally lasted 225 trading days,
nearly identical to the 223 days of 2005’s exceptional bear
rally. I have no idea why two radically different events would share
the same duration, but it is interesting. Also, note that major interim
lows in the USDX are most common in the months straddling new years.
The last interim low in late November 2009 fits right into this probability
band.
The key question
today is whether or not the dollar’s current bear rally will stretch
beyond the normal into the exceptional. I really doubt it technically
and fundamentally (which I’ll touch on later). Exceptional bear
rallies have only happened once every few years, and our latest one ended
less than a year ago. You also need extraordinary demand circumstances
to drive such rallies. And despite the media frenzy these days, the
sovereign-debt problems (such as Greece now) are nothing new. They
aren’t panic-grade.
Within the
context of the dollar’s broader secular bear, the USDX’s recent
surge merely looks like a garden-variety bear-market rally. Both its
magnitude and duration are right in line with the normal bear rallies
we’ve seen in past years. It is truly nothing special. And
until there is strong technical evidence that suggests otherwise, prudent
traders will throw in their lot with history rather than something new.
Delving deeper
into dollar-bear-rally technicals, it is very useful to consider them in Relativity
terms. Relativity is a trading system I developed years ago that
analyzes where a price is relative to its 200-day moving average in order to
discern high-probability-for-success buy and sell points in real-time.
The Relative USDX, or rUSDX, simply takes the USDX close divided by its
200dma and charts it over time.
The result is
rendered below in red. It reveals where the dollar is relative to its 200dma
as a constant multiple, ensuring percentage changes are perfectly comparable
across time. The 1.00x line represents the dollar’s 200dma.
The rUSDX falls lower in the dollar’s bear downlegs and then shoots
back up towards its 200dma in the subsequent bear rallies. The result
is a horizontal rUSDX trading range between 0.92x (major interim lows) and
1.00x (ends of bear rallies).
The rUSDX values
for the beginnings (green) and ends (red) of each major bear rally from the
second chart are noted here. Back in late November 2009, the rUSDX fell
to 0.923x (the dollar was trading at 92.3% of its 200dma).
Interestingly this was about as low as the dollar ever gets in relative
terms. If you look at all the major interim lows shown in green, values
around 0.92x are the most common by far. Thus this is the bottom of our
horizontal rUSDX trading range, the equivalent of support.
Why does the
dollar tend to bottom around 0.92x? Just as prices get overbought and
need to correct in bull markets, they get oversold and need to rally in bear
markets. Both types of countertrend moves are necessary to rebalance
away extreme sentiment. In the case of the dollar, whenever it sells
off fast enough to approach a relative 0.92x odds are there is unsustainable
near-term fear so a rebalancing bear rally is imminent. Over the years
we’ve accurately called many gold corrections (triggered by dollar bear
rallies) using this oversold-dollar metric.
The
dollar’s rally in recent months conformed perfectly to this
well-established secular-bear pattern. As I warned our subscribers at
the time in November, the US dollar was way too oversold. There was too
much pessimism and fear in it to be sustainable. Then right on cue as
we’ve seen so many times before, the dollar soon started surging
higher. So realize that the birth of our latest USDX rally was very
typical and predicted in advance. It was nothing new.
Conversely,
earlier this week the rUSDX surged to 1.026x (the dollar edged 2.6% above its
200dma). If you examine the red rUSDX readings at all previous
major-bear-rally tops, this is right in line with normal bear rallies.
This is why 1.00x is the top of our rUSDX trading range, resistance.
Once the USDX rallies far enough and/or fast enough to hit its 200dma, all
the fear from the preceding interim low is long gone. This sentiment
reset clears the air and allows the dollar’s fundamentals to once again
reassert themselves.
Before we get
into these fundamentals, it is important to understand just how normal and
unremarkable the dollar’s recent advance has been in technical
terms. It was a textbook-perfect bear-market rally, right in line with
the majority of bear rallies we’ve seen in this long secular bear to
date. With this rally looking mind-numbingly typical, today’s
bulls have a heavy burden of proof in trying to argue it is anything beyond a
normal bear-market rally. And if it is indeed a normal bear rally, it
is probably mature and ready to roll over.
As always after a
sharp USDX rally, bullish analysts love to make fundamental arguments to rationalize
their popular stance. In the last couple weeks for example, I’ve
seen a surprising number of analysts on CNBC claiming that the euro currency
is in jeopardy due to sovereign-debt issues. This death-of-the-euro
talk is woefully exaggerated though. One of many countries growing its
government too large and getting into trouble is no more of a threat to the
European Union than California defaulting on its “sovereign debt”
would be to the United States. Though the euro is a strange composite
currency, it isn’t going to implode.
The real issue
with the US dollar today is not the euro, but its own fundamentals. The
US dollar’s own unique supply-and-demand profile is what is going to
drive its international price in the coming years. And there is no
doubt at all that the dollar’s fundamentals remain terribly bearish.
The goofy US government is creating vast new fiat-dollar supplies at the same
time global demand is waning.
No matter which
socialist party is in power, the falsely-so-called Republicans or Democrats,
Washington perpetually lives far beyond its means. Despite the crushing
tax burdens it imposes on us Americans, it still can’t quit spending vastly
more dollars than it forcefully steals from us. So it is constantly
issuing new debt and creating new
currency to finance these appalling
deficits. Because of out-of-control government spending, the US dollar
supply continues to expand rapidly and relentlessly.
According to the
US Federal Reserve’s own data, since this dollar secular bear began in
July 2001 the broad MZM money supply of US dollars has surged 82.5%!
Given such a mammoth increase in the dollar supply, it is actually pretty
amazing the USDX was only down 33.8% bear-to-date as of this week. This
huge surge in the dollar supply equates to a compound annual growth rate over
this secular dollar bear of 7.3%. On average, 7.3% more dollars compete
for goods and services in each subsequent year!
But even while
supplies relentlessly increase dollar demand is waning globally.
Hardly a month goes by without some development among major central banks
detailing them scaling back their heavy exposure to US dollars and US
Treasuries. They have seen their so-called dollar reserves plummet in
value this decade due to Washington’s gross fiscal mismanagement.
They see Washington running gargantuan deficits leading to mushrooming debt
that will ultimately be inflated away. There is no other option.
Even today,
pushing 9 years into this secular dollar bear, all around the world central
banks and large investors have far too much capital allocated to US
dollars. In many cases, 80% to 90% of reserves are still denominated in
falling US dollars! Even if the dollar was in a secular bull, it would
be prudent to diversify such heavy exposure into other currencies like the
euro or even better physical gold bullion. But with the dollar still
relentlessly grinding lower and Washington laughing about it, the global
diversification away from the US dollar will only accelerate. The
Fed’s asinine zero-rate policy hurts terribly too, robbing dollar
investors of fair returns.
The
dollar’s own supply-and-demand fundamentals remain exceedingly bearish,
which buttresses the technical case that this currency’s recent advance
was merely a short-lived bear-market rally. In order to argue a bullish
case, the bulls have to dream up some fanciful scenario where global dollar
demand grows faster than Washington is printing the darned things. I
have yet to hear a remotely plausible one. If supply is growing at a
faster rate than demand, the only possible outcome is falling prices.
At Zeal, we were
not surprised at all by the recent dollar rally. For weeks in November
as the USDX became increasingly oversold, we warned our subscribers that a
sharp reversal higher was imminent. We pointed out that a fast dollar
bear rally would hammer commodities and commodities stocks. And indeed
it came to pass, especially in dollar-sensitive gold and gold stocks which
plunged in December and January on the USDX’s strength.
Conversely today with the USDX apparently topping, we’ve been aggressively
buying back into elite gold and silver stocks heading into the strong spring
seasonals.
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The bottom line
is despite all the dollar enthusiasm and bullishness these days, so far all
we’ve seen is a typical garden-variety bear-market rally.
Throughout the dollar’s long secular bear, similar rallies have
periodically erupted to erase oversold conditions and rebalance away
excessively pessimistic sentiment. These are merely technical events,
they don’t herald new bulls. Until global dollar demand growth
starts to exceed supply growth, the US dollar’s strong secular
bear will continue grinding lower on balance.
This is great
news for commodities and commodities-stock traders. A maturing dollar
bear rally means the headwinds driven by this sharply-rising currency will
likely soon be behind us. This has already created fantastic buying
opportunities in precious-metals stocks that are spreading into other
commodities-stock sectors as well. Once the dollar’s secular-bear
retreat resumes and mainstreamers catch on, the entire commodities realm will
again see massive capital inflows.
Adam Hamilton,
CPA
Zealllc.com
January 15, 2010
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