Unusual Opportunities In The Dollar

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Includes: UDN, UUP
by: QuandaryFX

Summary

The dollar has rallied strongly over the past few years favoring a short opportunity in the future.

A very predictive relationship - the relative CPI - is indicating that it is time to short the dollar.

As the United States' largest trade partner, Eurozone strength leads to dollar weakness.

If you're looking for an unusual opportunity in the foreign exchange markets, look no further than the U.S. dollar. Since the financial crisis, we've witnessed quite the roller coaster in the dollar index (NYSEARCA:UUP).

During the crisis, we saw the dollar rally by over 10% as the world witnessed a "flight to quality" in which investors across the global poured capital into U.S. markets to purchase government securities, driving effective yields negative for a period of time. The next significant run-up in dollar strength occurred in 2014 and 2015 as the Federal Reserve's stimulus programs reached their natural conclusion and drew to a close. The simulative action of the central bank caused global investors to once again purchase U.S. assets to participate in heightened economic activity propelled by cheap cash.

The astute investor at this junction should be asking, "How high is too high?" Based on the run-up in the dollar strength, the most favorable reward per risk setup favors selling the dollar. For those adventurous enough to risk outright exposure to the foreign exchange markets, here's an attractive opportunity to trade against the recent dollar strength.

The core activities of any economy can be measured by a few simple metrics such as GDP, unemployment rate, and inflation. Each of these indicators in and of themselves speak very little as to the strength of the currency in which economic activity occurs. For example, if the U.S. unemployment is rising or falling, it says nothing as to the supply or demand balance for U.S. dollars. However, very interesting findings show up when we turn the data on its head and look at economic activity in relative terms.

I have found that one of the most reliable economic indicators for forecasting currency strength or weakness is something which I call "relative CPI". The idea is this - by examining the inflation rate of two rival economies, we can determine which way funds are likely to flow between the two regions. If we can determine the likely flow of funds, we can determine if a currency will weaken or strengthen, all else equal. Here's a chart of the CPI of both the Eurozone and the United States.

Do you notice how for the most part, the U.S. and Eurozone experience very similar changes in CPI? This is because many of the global forces of boom and bust affect most of the world at roughly the same time. It is only when we examine things on a relative basis that we are able to strip out the global effects and focus on the relationship between the two nations.

Here's how it works. When the U.S. economy is experiencing more growth than the Eurozone economy, there will be heightened demand for U.S. dollars. The idea is that if an economy is growing rapidly, all else equal, funds will flow into that economy, propping up both the economy and the strength of the currency. As you can see in the chart below, this relationship is pretty predictive - if the economic balance between the Eurozone is shifting such that the U.S. is growing much faster than the Eurozone, the dollar tends to rise. The converse is also true.

Over the last two years, we've seen the U.S. CPI growing at a slower rate than the Eurozone CPI. When this happens historically, the dollar tends to fall over the next year. This relationship is very strong, consistent, and implies that the dollar will decline over the next year. "But wait," you say, "why the Eurozone?" I'm glad you asked.

The Eurozone is the top trade partner of the United States, representing nearly 18% of all international business - relative changes in the two economies will by necessity dictate currency direction. Since the United States' largest trade partner has started growing faster than the Eurozone, the flow of capital will inevitably leave the U.S. and make its way into the Eurozone. With the relationship already underway and the dollar near record highs, it really 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.

Additional disclosure: I will capitalize on this opportunity through short-term investments in the spot foreign exchange market.