Has The Dollar Turned?

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Includes: DRR, ERO, EUFX, EUO, FORX, FXE, UDN, ULE, URR, USDU, UUP
by: Perry Kaufman

Summary

The U.S. dollar has been strengthening for months, but is now showing signs of stabilizing.

Using a new technique, "trend strength," we can assess the direction of the dollar more accurately.

We see the dollar as weakening before the Fed acts to raise rates.

If you look at enough data and market commentary you'll find enough reasons to be either long or short the dollar. Instead, keeping focused on the biggest issues will most often get you the right answers. Nuances just seem to add noise to the decision process and increase confusion rather than clarity. As Mark Twain said, "The researches of many commentators have already thrown much darkness on this subject, and it is probable that if they continue we shall soon know nothing at all." It may be comforting to know that little has changed.

What are the most important factors in deciding the direction of the U.S. dollar? We believe that you only need:

  1. the strength of the interest rate trends,
  2. the strength of the equity index trends, and
  3. the strength of the FX moves themselves.

Note that each item indicates the "strength" of the trend. As an algorithmic-driven organization, we reduce everything to numbers. Trying to give values to various fundamental and news announcements is too difficult and inaccurate. The "trend" is a clear concept as long as you don't hang your hat on a single value.

Measuring Trend Strength

In order to understand the following charts, we need to define trend strength. It is the weighted average of a set of individual trends spanning the calculation periods from 30 to 120 days, distributed in equal percentages. If the percentage is 100, then we would use 30, 60, and 120-day averages (each one doubled the previous). If the percentage is 50, we use 30, 45, 67, 101, 151, and so on (each a multiple of 1.5 times the previous). If we don't use percentages then we bias the sample to the slow trends. Let's say we use equal increments of 5 days. Then the difference between a 10 and 15-day average is 50%, but the difference between a 95 and 100-day average is only 5%. So the slower averages will give very much the same answers.

If we take the trend direction of each moving average, then find the number of moving averages that point to an upwards trend, divided by the total number of averages being used, we get the Trend Strength Index. We think it's a good representation of the true trend.

Interest Rate, Equity Index, and FX Trend Strength

Interest rates are a primary factor in driving FX prices because money flows to countries with higher interest rates net of inflation and geopolitical risks. For most of the countries that we review, geopolitical risk is negligible, and inflation is modest. The chart below shows the futures prices of the U.S. 10-year note and the Eurobund, both with a maturity of 8 to 10 years.

Data source: CSI

The scale for the 10-year notes is on the right and the scale for the Eurobunds on the left. We've fiddled with the scales to show how closely they track each other, although the move from high to low in the U.S. notes is only 1.17% while the bund moved 4.5%. It is interesting that they go up and down in sync.

The chart below shows the average trend strength of U.S. interest rates (both long and short maturities, from futures) compared to an average of European, British, Canadian, Australian, and Japanese rates. After seeing the price patterns, it should not be a surprise that the trends also track very closely, turning up and down at the same time and gaining and losing strength together.

Data source: CSI

The green line, representing the trend strength of U.S. rates, shows that prices have recently been dropping (yields rising). But instead of overall yields falling in the Eurozone because of pending quantitative easing, both markets show downward price trends (rising yields). We can attribute that to expectations rather than actual events. Trends have been up for months in anticipation of European easing and U.S. rates have followed.

Equity Index

What do equity index markets tell us? We would expect counties with the value of their currencies declining to have improved trade and overall better corporate profits (especially international companies). On the other hand, the U.S. should see a drop in exports due to a stronger dollar. Money should flow out of Europe and out of their equity markets into the U.S. Has that happened?

In fact, the chart shows us that both U.S. and other world markets (7 European, 4 Asian, Canada, and South Africa) have been doing well. That is, they all maintain a fairly good upward trend in equity index prices. It appears as though globalization has been achieved in the world's major economies.

Data source: CSI

What Does This Mean for the USD?

The Dollar Index trend strength (shown below inverted so that a stronger dollar is a lower move, the same as currency futures), started its uptrend in June 2014, increased in strength quickly, then remained strong until the beginning of May. It's now weakening and sits at neutral (zero on the chart).

Data source: CSI

This weakening corresponds to the recent trend towards higher yields. But where the Eurobund declined a larger percentage than the U.S. 10-year note, it is also rising faster. This is all contrary to our idea that Quantitative Easing in Europe should weaken the euro. Our conclusion is that markets move on anticipation and future rate changes are already priced in.

Given that we have already seen a turn in the trend of the dollar, why would it continue?

  1. The European economy (as seen by the equity market, not individual employment) is doing well and Quantitative Easing should give it more of a boost.
  2. Investors expect improvements in Europe and will move money to take advantage of investing in European markets. That will increase the value of the euro against the dollar.
  3. The U.S. Fed would not want to raise rates if it means a much stronger dollar. That could have a serious, negative effect on U.S. exports. It would be best if the Fed waits for a strengthening of the euro, so that raising rates would not cause a new high in the dollar.

Our target for the euro is between 1.15 and 1.20, not above 1.20 until Europe regains full health. We then expect the Fed to raise rates and drive the value down again to 1.10. We think new highs in the dollar are unlikely and undesirable for the U.S. economy.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.