We had three bullish reports calling for a dollar (NYSEARCA:UUP) breakout since October 10th (See here, here, here). We think the strength can continue with investors running for cover from euros and European financial risk.
Here's Our Recent Calls
Source: Interactive Brokers
Above are our three recent calls that we were bullish on the dollar as we thought it could break out. The last call we needed it to start moving up to confirm and it did.
Here's What We See Now
Source: Interactive Brokers
As we zoom out on the dollar ETF UUP you can see the dollar has just broken out of a longer term base.
The action that decided where it failed and dropped back looks now a little more powerful than past tries.
We believe there is a fundamental reason for a bigger potential breakout.
Bonds Dropping Worry Europe: Investors Need Dollars
Dollars are seen as a safe haven.
The ECB is keeping rates low of course to drive the economy. An underlying need to drive the economy however is to keep weaker European banks on life support. Many European banks are struggling to stay afloat. Lower rates help keep them breathing.
A spike in yields and a drop in bond values are a major risk. This risk comes suddenly and unexpectedly.
As weaker banks in Europe have to deal with declining values of their bond holdings their financial health comes into question.
This fast sudden bond drop is a risk for the European banking system. If so it's a risk for the euro as well. That's why investors are clamoring for dollars as soon as bonds dropped. The two moves happened together.
We see two main reasons for European investors to need dollars.
1) Selling Euro Debt
2) Selling US debt
Selling Euro Debt
Selling Euro Debt means investors are worried what higher rates will mean for EU banks (as we said above).
Higher inflation could also stall ECB's bond buying. The ECB is the only buyer in town. If they stop buying (which we think inflation can cause) then the bond rout continues. Investors need to get ahead of that. That reminds them the Eurozone is weak and so they want dollars.
Exiting EU debt also could point to US debt demand to come. The US banks are perceived to be more stable than the EU system. Selling EU debt could cause diversification to want to buy US debt in the future.
Selling US Holdings
As European investors sell their EU exposure they probably sell some foreign exposure. That foreign exposure may have been hedged by shorting dollars.
Let's think about it.
If I'm an EU investor and own US debt I may want to hedge out my foreign exposure in that security by shorting the foreign currency and buying my own currency. That shorting of foreign currency cancels out my holding's foreign currency exposure. As I now sell that US debt I need to close out my currency hedge. That dollar short cover makes me need dollars.
Selling bonds begets dollar demand.
If bond routs continue the dollar should go up.
As inflation causes worry that the ECB will stall their historic buying campaign the dollar goes up.
We think the dollar has already broken out.
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