Is the Dollar Ready to Rally Soon?

Includes: FXE, UDN, UUP
by: Acting Man

A Few Comments on the Stock Market

On June 13, we posted "Deliberations on the U.S. Stock Market," which contained the following chart showing our proposed short term Elliott wave count and a possible future path of the market derived from it:

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Our proposed wave count for the S&P 500 and the future stock market path derived from it as of June 13.

This has now turned out to have been quite a lucky guess (so far). As we have pointed out on several occasions as the Greek debt crisis played out, there was heightened "crash risk" for a period of about two weeks – this is always the case when an already deeply oversold stock market is faced with a fundamental backdrop that has potential to deteriorate in such a manner as to create a sharp increase in the level of uncertainty. However, as we also noted, the probability of a bounce out of oversold conditions is always much higher than the probability of a waterfall decline.

In this particular case, it all seemed to hinge on the votes of a few PASOK backbenchers – some of whom were suspected of possibly voting against the new austerity measures that were the precondition for the next EU/IMF loan disbursement to the Greek government. If either the confidence vote faced by the Papandreou government or the vote on the austerity package a week later had failed, the markets would have been confronted with the need to discount the above mentioned increase in uncertainty. What kind of uncertainty? It would in fact have been very similar to the Lehman bankruptcy and the demise of Bear Stearns before it. Market participants would have been forced to gauge the risks posed by the complex web of interconnectedness of financial intermediaries across the euro area, the risk of a speeding up of "contagion" to the other peripheral bond markets, the consequent risk of further national bankruptcies on the euro area's periphery, and the resulting further deterioration of euro area bank balance sheets. Greece's biggest banks would have become officially insolvent by being forced to mark their losses on Greek government bonds to market. ECB funding of Greek banks would have become impossible or at least very difficult. A series of cascading cross-defaults may well have resulted.

This is why we held that as long as the situation was unresolved, there was a fairly high "crash risk" for the stock market. Conversely, it was clear that the stock market and other "risk assets" (commodities and high yield currencies) would seize on any emerging improvement in the news flow and accordingly relieve oversold conditions by rallying. The important thing to keep in mind here is that it is the lessening of uncertainty that has produced this reaction: The system's interconnectedness no longer poses an imminent problem that requires to be discounted in what would likely have been a disorderly fashion. In addition to this, it has turned out that many market participants have been "shorting into the hole," i.e., they have increased their short positions when the market was already deeply oversold, in the expectation of a bigger decline. The unwinding of these positions has produced an especially spirited rally over the past five trading days. On June 28, we noted:

“The S&P 500 Index has bounced off its 200 day moving average and a slight RSI divergence and a tentative MACD buy signal indicate that a short term bounce may still be in the cards. In all likelihood the news flow from the euro area will determine the short term outcome. Alas, we continue to believe that the medium to longer term outlook for stocks is quite negative.”

The short term bounce has now turned into a quite vigorous rally that looks so far almost exactly like the move we penciled in on our June 13 wave count chart. Nevertheless, nothing has changed with regards to our assessment quoted above. The strong short term rally does not alter our negative medium to long term outlook, which is based on indicators that have an extremely good record of warning of longer term trend changes - see our June 28 missive for details.

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The SPX is now approaching a zone of resistance, after a strong rally on very little volume. The time period during which the SPX tested the 200 day moving average twice was a period of heightened "crash risk." The possible path we have drawn in here – roughly in keeping with what we suggested in mid June – will have to be reassessed as time goes on. One will need to closely watch whether new divergences develop and how the sentiment backdrop evolves in coming weeks. One of the reasons for the "stinginess" of our orange "possible path" line is likely developments in currencies.

The Global Economic Backdrop

The recent market rally was likely the market's way of dissipating lingering concerns about the end of the Fed's QE2 program. When QE1 ended, it took about one month before the market succumbed to a wave of selling. If one ponders the fundamental backdrop, one thing that is quite clear is that the latest "rescue" of Greece has not materially changed the problem faced by the euro area. It buys more time, but buying more time has hitherto only made things worse. A number of economic data in the U.S. have come in slightly "above expectations" over the past week, which has provided even more fuel to the rally in the stock market, but as Mish notes in "Manufacturing ISM Weaker Than It Looks," the PMI data were largely an artifact of inventory restocking, which accounted for the vast bulk of the "surprise increase." Looking under the hood of the report, it turns out that order backlogs, imports and exports all trended lower. As we noted on June 24, the euro area's composite PMI has meanwhile dropped to its lowest level in 20 months. See also this chart for more color.

“Private-sector growth across the 17-nation eurozone in June was the weakest since October 2009, led by a sharp slowdown in manufacturing activity, according to preliminary purchasing managers index data released Thursday. The Markit eurozone PMI composite index fell to 53.6 in June, a 20-month low, from 55.8 in May. Economists had forecast a smaller decline to 55.6. A reading of more than 50 indicates growth in activity, while a figure of less than 50 signals contraction. Manufacturing PMI fell to an 18-month low of 52.0 from 54.6 in May. Services PMI declined to a six-month low of 54.2 from 56.0 in May. "The euro area's economic growth surge has lost momentum at a worrying rate in the past two months," said Chris Williamson, chief economist at Markit. "While the average PMI reading for the second quarter as a whole suggests that the economy grew by around 0.6%, down from 0.8% in the first quarter, the reading for June was consistent with a quarterly growth run rate of just 0.4%."

Shortly thereafter, it turned out that China's latest manufacturing PMI is only a smidgen away from contraction territory, as it fell to a 28 month low in June.

As Xinhuanet reports:

“The manufacturing sector expanded at its slowest pace in 28 months in June, with the Purchasing Managers Index (PMI) falling 1.1 percentage points month-on-month to 50.9%, according to the China Federation of Logistics and Purchasing (CFLP).

It is the third consecutive month of decline for the PMI, a gauge of manufacturing expansion, in China, as the government fights soaring prices by withdrawing liquidity from the market. The PMI figure was 52% in May, 52.9% in April, 53.4% in March, 52.2% in February and 52.9% in January.

A reading above 50% indicates economic expansion. One below 50% indicates contraction. China's PMI has stayed above the boom-or-bust line for 27 months in a row. Concerning the sub-indexes, the purchase price index, which measures the cost of raw materials, led the declines with a month-on-month drop of 3.6 percentage points in June, while the new orders index, which reflects domestic demand, fell 1.3 percentage points from May to 50.8% in June. The CFLP data also showed that the backlog orders index and raw material inventory index posted declines of more than 1 percentage point last month.

"The PMI decline in June shows that the country's economy is likely to grow at a slower pace this year," Zhang Liqun, a researcher with the Development Research Center of the State Council, said in the CFLP statement. To break down the June data by 20 industries, the PMI reading for 12 sectors such as electronic machinery and food processing and manufacturing remained above the boom-or-bust line of 50%, while the reading for chemical and textile industry as well as transportation equipment manufacturing was below 50%. The PMI data from the logistics federation and the National Bureau of Statistics was lower than market expectations of 51.5%, but higher than the HSBC's index of 50.1% compiled by the Markit Economics Ltd.”

(our emphasis)

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A chart of China's PMI and three of its sub-components via "Also Sprach Analyst."

An important near term gauge of unemployment in the U.S., the weekly initial unemployment claims data, also continues to stubbornly cling to a level that has historically suggested weakness in the labor market (the demarcation generally regarded as important is the 400,000 claims level – once the four week moving average of weekly unemployment claims moves decisively below this level, employment is expected to expand. Conversely, a rise above this level is held to indicate a weakening employment picture).

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Weekly initial claims in the U.S. – still in territory generally associated with economic contractions.

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The four week moving average of weekly initial claims remains above the 400,000 level as well.

Lastly, it is worth noting that the ECB remains set on raising its administered short term interest rate. Whenever ECB president Jean-Claude Trichet utters the words "strong vigilance" repeatedly in public, he intends to convey to financial markets to expect an imminent rate hike. As far as central bank policy goes, it is generally better if the central bank errs in the direction of tighter rather than looser policy, but it should be stressed that it is simply impossible for a committee of planners to plan the correct interest rate.

The central bank's administered rate may occasionally coincide with the natural rate indicated by society-wide time preferences by sheer luck, but usually the central bank imposed interest rate will diverge from the rate that would be set by the free market and will thus be less than optimal. Most of the time, central banks tend to err on the side of easy money. We have discussed the problem in more depth in "The Errors and Dangers of the Price Stability Policy." The currently preferred method of setting rates in such a way as to ensure that a price index that purportedly represents the "general level of prices" rises by a fixed percentage per year, is in fact an extremely dangerous policy. It is beset by so many theoretical and practical errors that it serves at best as a cautionary example that vividly demonstrates the impossibility of central economic planning. As Jesus Huerta de Soto points out, central bank policy will always be doomed to failure as the central bank-led financial system is faced with a variation of the socialist calculation problem. What central bankers would need to know in order to determine the "correct" interest rate is simply unknowable. As de Soto notes in "Money, Bank Credit and Economic Cycles:"

Indeed, the current financial system rests on a monopoly one government agency holds on the chief decisions regarding the type and quantity of money and credit to be created and injected into the economic system. Thus it constitutes a financial market system of “central planning” and therefore involves a high level of intervention and is to a great extent “socialist.” Sooner or later the system will inevitably run up against the impossibility of socialist economic calculation, the theorem of which maintains it is impossible to coordinate any sphere of society, especially the financial sphere, via dictatorial mandates, given that the governing body (in this case the central bank) is incapable of obtaining the necessary and relevant information required to do so.

At present, the ECB is evidently set to increase interest rates further. As Bloomberg reports:

The euro was 0.3% from a one- week high against the dollar on speculation the European Central Bank will raise interest rates next week even as Greece struggles to avoid a default. The 17-nation currency traded near a two-week high against the yen after ECB President Jean-Claude Trichet yesterday said policy makers are in "strong vigilance mode," boosting rate- increase expectations.


“The ECB raised its benchmark rate in April for the first time in almost three years, lifting it by a quarter point to 1.25%. The central bank will meet on July 7.

‘‘We’re taking the decision progressively to anchor inflation expectations,” Trichet said at a press conference in Amsterdam following a seminar with central bankers from the Asia-Pacific region. “As far as we’re concerned, we’re in strong vigilance mode,” he said, repeating a phrase the ECB uses to indicate a rate increase is imminent.

(our emphasis)

To this it should be noted that the fact that central banks like the ECB focus on "price indexes" when making their interest rate decisions with the aim, as Trichet puts it, to "anchor inflation expectations" (the central banker euphemism for boiling the frog slowly), they are focusing not only on something that attempts to measure the unmeasurable, but at best represents a lagged effect of monetary policy. The reality is that inflation – in the true sense of the word, i.e. the rate of expansion of the money supply – has stalled out in the euro area for the past year. More specifically, the latest monthly growth rate of euro area TMS (true money supply) has turned negaitve at minus 0.9% annualized, while the year-on-year rate of growth of euro area TMS has slowed to a mere 0.9%. We use the TMS data calculated by Michael Pollaro, who provides an extensive explanation of this money metric with sources and references here. Interested readers can download Michael's latest data via the links to the "Contrarian Databank" provided on this site (on the left hand side bar).

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Euro area money supply and ECB credit. The growth rate of ECB credit has turned deeply negative in recent months while the year-on-year growth in money TMS has slowed to a mere 0.9%.

This means that the timing of the ECB's rate hike – the implementation of which is a result of euro-area CPI recently clocking in at 2.7% annualized, which is 0.7% above the "target inflation rate" set by the ECB – is rather odd. The ECB is well known for the often unhappy timing of its rate hikes, as the July 2008 rate hike – which it had to quickly take back – amply demonstrates. At the time the ECB was worried about the soaring crude oil price – ironically, just before it commenced to collapse by over 70%. The rise in the price of crude oil at the time was the final lagged effect of the global credit and money supply expansion of the 2000-2006 period.

The current ECB rate hike cycle could well prove to be similarly ill-timed (from the point of view of the financial markets, that is), as the recent weakening of economic activity in the euro area indicates that the slowdown in money supply growth over the past year is already beginning to bite.

The U.S. Dollar

When discussing the U.S. dollar in the past, we have pointed out that one must keep a close eye on certain indicators that tend to give early warning of an impending rally – more on this follows further below. The reason why we are taking up the topic again is that the recent aggravation of Greece's government debt woes has once again directed a spotlight on the problems euro area banks face in obtaining dollar funding. As we noted in "Greece Continues to Pose a Major Risk," there have been growing concerns about the exposure of U.S. money market funds to euro area banks – which has not only resulted in money market funds cutting said exposure in recent weeks, but has also led to outflows from institutional money market funds, as Barron's reports:

Concern about Greece and other sovereign debt issues spurred large institutional investors in money market funds to pull their money at the fastest pace in 15 months, according to iMoneyNet.

So-called prime institutional money markets — the type with lower fees and big upfront requirements used by large investment funds and managers — lost $39 billion to net withdrawals in the week ended Tuesday. In the past two weeks, the total taken out of such funds totaled $75 billion. By contrast, institutional money funds that buy just U.S. government-backed securities had $27 billion in net deposits.

The currency swap lines between the Fed and European central banks have in the meantime been quietly extended beyond their putative August deadline - a sign that the central banks are well aware that risks in this particular area of bank funding continue to persist.

In addition to the bank funding issue, the dollar has become a favorite funding currency for "carry trades" – in the wider sense of the term. This is why there is a well-established negative correlation between the U.S. dollar and so-called risk assets, including of course the foreign currencies that are the favorite target of the carry trade (in the more strict sense of the term, a carry trade attempts to exploit an interest rate differential such as that between different currencies). There is no simple cause-effect vector at work, but rather a feedback loop. This is to say, not only can a sudden rise in the dollar lead to a liquidation of risk assets, but the opposite is just as likely - i.e., a fall in risk asset prices can cause a rise in the dollar, as dollars need to be bought to pay back loans that have been used to finance risk asset positions.

It is important to keep in mind here that the fundamental backdrop for the U.S. dollar remains to date quite bearish – not only is the Fed continuing its "almost-ZIRP" policy of keeping the Fed Funds rate target between 0 and 0.25%, but growth in U.S. money TMS has been quite brisk up until recently . While the most recent monthly annualized rate of growth of "broad" TMS-2 has clocked in at a fairly slow (by recent standards) 3.6%, "narrow" TMS-1 has grown at a hefty 18.4% annualized in May. The year-on-year growth in TMS-2 currently stands at 11.1%, while year-on-year growth in TMS-1 stands at 11.3%. The slowdown in the monthly annualized TMS-2 growth in May was largely due to a decline in savings deposits of 3.7% (also at a monthly annualized rate). By economic categorization, uncovered money substitutes at private banks fell by 10.5% annualized in the month of May – which buttresses our previously noted contention that following the end of QE2, the deflationary pull of private sector deleveraging could become an important factor slowing down U.S. money supply growth (until the Helicopter pilot embarks on 'QE3', that is).

As it were, these data describe the past and not the future. They tell us that the effects of the Fed's monetary pumping are likely to continue to propagate through the economy and raise various prices, but they do not tell us anything about the extent of monetary inflation in the near future. In the absence of active pumping by the Fed, commercial banks must create more credit than is paid back, otherwise money supply growth could even turn negative for a while.

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U.S. money TMS-1, TMS-2, their yearly rate of growth, plus the growth in M2, and below Fed credit outstanding and its 12-month growth rate. As can be seen, there has been a close correlation between the expansion of Fed credit and the expansion in the money supply since the 2008 crisis. Unless the commercial banks increase their inflationary lending, money supply growth seems likely to stall out once QE2 ends.

We want to make two points here: there is on the one hand a purely technical reason that could lead to a dollar rally – namely the dollar funding needs of euro area banks and a possible liquidation of "carry trades" (there are a number of potential triggers that could lead to carry trade liquidations, such as e.g. a worsening of the recent slowdown in economic activity in China and/or Australia, which may lead to a reassessment of commodity price trends and the exchange rate and interest rate backdrop of the Australian dollar, to name but two) and on the other hand there is a potential fundamental development, in the form of a potential slowdown in money supply growth following the end of QE2.

As noted above, in order to gauge the likelihood of a rally in the dollar, we are also keeping an eye on certain technical signals. Take a look at the chart of the dollar index futures (DXY) below:

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The U.S. dollar index – although it has recently put in a higher low, this is still a bearish looking chart at first glance. The best that can be said about it is that the downside momentum has slowed. However, take a look at the red line below the price chart. This shows the net positioning of large speculators in DXY futures. In spite of the fact that the dollar has not made any net progress over the past three months, these traders have begun to position themselves for a rise in the dollar.

The behavior of large speculators in DXY futures is one of the signals we closely watch. Historical experience has shown that they tend to begin to position themselves net long in DXY futures shortly before rallies in the dollar commence. This change in positioning can at times involve a lead time of several weeks and usually the dollar is still immersed in a downtrend while it happens. Observe on the next chart how the current period compares with the dollar low made in 2008:

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On this chart, the net position of large speculators is identified by the blue line. Observe how this group of traders covered its shorts and went slightly net long in 2008 well before the dollar put in its final low. If one looks closely, one can see that these traders always tend to change their positioning shortly before a bounce in the dollar commences. The recent repositioning is very similar to what occurred in 2008. This probably means that there is still time before a durable low is in place, but clearly it represents an early warning signal.

Another (slight) warning signal is the recent downturn in gold and silver prices. Gold has by now weakened considerably from its late April high, as the so-called safe haven bid has come out of it now that the Greek default can has been kicked further down the road. Gold has a well-established tendency to weaken or strengthen ahead of turns in the dollar. However, this signal is currently somewhat impaired due to the influence the ups and downs in the euro area's debt crisis have on the gold price. Nevertheless, it should not be ignored. It remains to be seen whether a new low in DXY will be confirmed by a new high in gold – at the moment this seems rather unlikely.

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Gold vs. DXY (green line) and the gold price in euro terms (below). Currently, gold and the U.S. dollar are both weakening. Often this is a sign that the dollar is closing in on a more durable low.

There are several reasons to believe that it will still take a little while for the dollar to actually bottom. One of them is that small speculators (the red line in the commitments of traders chart above) have also amassed a very large net long position and this group is traditionally most aggressive near highs and not as well versed in spotting likely lows as the large speculators. A further short term decline may serve to wash out some of these positions. The other reason is the current state of technical indicators in DXY and the euro.

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DXY – currently, there is an MACD sell signal in force and the short term trend remains down. Note the medium term positive and short term negative divergences indicated above by the blue and red dotted lines. The orange solid line indicates a potential future path in keeping with the likely time line for the next stock market high and the evolving buy signal from speculator positioning in DXY futures. A near term decline would likely serve to decrease the net long position of small speculators. If a low is put in over the next few weeks, it should be accompanied by another set of divergences with RSI and/or MACD (in principle any type of momentum based oscillator will do, but we like to keep it simple).

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A weekly chart of the euro-dollar cross – the triangle that has been built in recent weeks suggests that one more leg up should be expected. Note that the short term trend appears still intact – there are no divergences in evidence as of yet. However, there is a longer term negative divergence in place. In essence this is the opposite of what we see in DXY, in which the euro has a roughly 60% weighting. The orange solid line indicates a possible path for the euro as a corollary to the dollar's projected path.

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As an aside to the above, here is a two year chart of the CHF-euro cross. The Swiss franc's uptrend against the euro has been accompanied by a growing loss of momentum (as indicated by the RSI divergence – red dotted line). Last week the Swiss franc has fallen to a first lateral support level that currently coincides with the 50 day moving average. A retest of the pair's uptrend line (the green solid line) seems likely to occur in coming weeks, which would argue for more near term euro strength as well.


It is of course possible that the speculative paths for stocks and currencies proposed above will evolve in a different manner (we have a crystal ball, but usually it's cloudy). As time goes on, market action may necessitate a reappraisal. However, the probability of a sizable rally in the dollar seems to be increasing. In recent weeks, the dollar has "put everyone to sleep" by its directionless trading. The momentum of its medium term downtrend has however weakened considerably, even though the short term trend continues to point down. If a global "growth scare" and the usually associated "deflation scare" become manifest later this year, the dollar could easily make another attempt to rally to the upper boundary of the trading range it has inhabited since 2008. Note that all of this depends on the idea that the well-worn negative correlation feedback loop between waxing and waning "risk appetite" and the U.S. dollar remains in force. No inter-market correlations are immutable in the long term, but it seems to us that this particular one remains in force for the time being. This is a logical consequence of the dollar's role as a funding currency.