The Dollar Has Peaked And It Is Time To Short

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Includes: UDN, UUP
by: QuandaryFX

Summary

For the past 7 years, the dollar has been driven by the Treasury markets - this relationship is changing.

As the recovery enters full swing, it is important to not make decisions on pure economic factors, but rather the positioning of other traders.

Market statistics do not lie - we've been here before and the future does not look bright for the dollar.

Over the past twelve months, a momentous rally of over 12% has occurred in the United States dollar (NYSEARCA:UUP). In a rally fueled by major macroeconomic developments in the United States economy, the dollar is now sitting at levels not seen in over a decade. Despite the elevated heights of the dollar, I believe that we have reached a peak and it is now time to consider exiting all open dollar positions. As I will discuss in this article, macroeconomic forces and funds have already entered the markets, leaving very little upside for the investor late to the game.

Economic Landscape

For the past 7 years, action in the dollar has been primarily driven by the United States Treasury market. During the financial crisis, global investors bought Treasuries in search of safety of capital, even accepting negative rates, when accounting for inflation. For global investors to purchase Treasuries, they must sell their base currency and purchase dollars, since Treasuries are denominated in dollars. This led to an inverse relationship between the dollar and the 10-year Treasury note during the most volatile months of the financial crisis (September 2008 - March 2009), as can be seen in the chart below.

The significance of the chart is this: understanding United States bond flows is crucial, at times, for determining the future direction of the dollar. At present, the United States Treasury market is still saturated with the actions the Federal Reserve made during the financial crisis. Through quantitative easing, the Federal Reserve essentially printed money to purchase Treasuries to manipulate the yield curve. The goal of the Federal Reserve was to decrease the rate at which businesses and individuals can obtain loans so that they can pursue projects which deliver progressively lower yield. The Federal Reserve hoped that through heightened economic activity, greater employment would result and the overall economy would improve. I believe the Federal Reserve accomplished this purpose, as seen by unemployment at 7 year lows.

Something very important occurred in the Treasury markets in September of 2012 - the third round of quantitative easing. Through QE3, the Federal Reserve actively entered the mortgage-backed securities market and sought to lower mortgage rates through the same money printing process it pursued immediately following the financial crisis. This is important to note in that through QE3, the Federal Reserve shift its attention from primarily the Treasury markets, as seen in the chart below.

When the Federal Reserve shifted its focus to the MBS markets, the crisis relationship of inverted behavior between the Treasury and the dollar began to shift. During this time period, large funds, investors, and traders reasoned that they could no longer rely directly on quantitative easing actions for determining market direction of the dollar. Since the Federal Reserve was no longer solely focused on Treasuries, market demand factors, such as natural economics, could once again dictate the trading patterns of the dollar.

In September of 2014, the dollar began a meteoric rise. In the most sustained rally since 2009, funds piled into dollar-denominated securities. However, as can be seen in the chart below, this time, investors weren't primarily trading Treasuries.

Since 2014, global investors have been pouring capital into the United States for entirely different reasons than safety and anticipating the Federal Reserve: recovery. With unemployment at 7-year lows, stock markets striking all time highs, and industrial production increasing on a year-over-year basis for 5-years straight, it is safe to say that a full blown recovery is occurring in the United States. Wise investors identified this recovery in 2014 and poured capital in the United States economy to directly participate by either holding assets or investing business capital.

The Present

To trade successfully, we not only need to accurately identify the factors driving markets today, but also reason through what other investors know. If everyone "knows" the markets are going up, but most available capital is fully invested, the markets will be physically unable to rise and liable to decline. I believe the state of the dollar is this - the chips are already placed and all major players are fully vested or exiting positions. While the dollar has experienced a historic rise over the past few years, it has started to decline over the past few months following a cataclysmic day of trading in March of this year.

Market statistics can give us guidance during times of uncertainty. Markets follow rhythmic patterns that can be measured, quantified, and tested. For example, over the past 12 months, the dollar has risen over 12%. Statistically speaking, this type of rise in a major currency primarily happens during crises - the financial meltdown in 2009 and collapse of Long Term Capital Management in 1998. In each of these situations, the dollar had significantly declined over the next year. In 1998, the dollar rallied 14%, but over the 12 months following the rally, declined 3%. Similarly, in 2009, the dollar increased 17% at one point, but over the next year it had collapsed by over 9%. I believe that this time is not different. The dollar has rarely experienced movements of this magnitude in which there was substantial follow through. In fact, of all periods in which the dollar rallied 12% or more, it fell by an average of 2% in 66% of the year that followed. In other words, the odds don't favor buying or holding the dollar.

Conclusion

As the crisis mentality of the markets fade into memory, I believe we will see a fall in the dollar. Despite that fact that economics seem to indicate that it would be time to buy the dollar to participate in the recovery, we need to remember that trading on economics is like driving through the rearview mirror. Market statistics strongly suggest that the dollar has topped and investors would be wise to heed its warning. I believe that it is time to short the dollar.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.