The Summer Dollar Rally?

by: Rahul Salgia


Commercial hedgers have unwound their bullish bond position.

Speculators that were once bullish bonds are now short bonds.

Smart money is extremely net short the euro.

The CME's FedWatch tool indicates a 99% chance of the Federal Reserve raising the Fed funds rate 25 basis points to 1.00-1.25%. The irony is that even though short-term rates are headed higher, longer-term rates are headed lower. After the Fed raised rates in March, the 10-year yield peaked at 2.6, and now is 2.19. 10 Year Treasury Rate Chart

10 Year Treasury Rate data by YCharts

Similarly, the 30-year yield peaked at 3.2, and it's now at 2.85%.30 Year Treasury Rate Chart

30 Year Treasury Rate data by YCharts

These lower yields show that traders have priced in a slowing economy.

Several traders anticipated that interest rates and the dollar would trade higher, but actually the opposite happened. Commercial hedgers (smart money) on the other hand positioned themselves on the opposite direction. As of March 14 2017, they were net long 99,537 contracts, and this was the most bullish reading going back six years.

The media kept running headlines that interest rates would head higher. Short-term rates are higher, but the long-term rates are lower than market expectations. If we fast forward to today, the commercial hedgers are net short 22,407 contracts while the non-commercial futures traders are net long 22,910 contracts. Sentiment turned a sharp 180, as now the smart money is neutral about their opinion about the long-term bonds.

As bond prices surged, the dollar index sold off approximately five percent from its highs this year. One important feature of this index is that it is a basket of several fiat currencies. 57.6% of the index consists of the euro, 13.6% consists of the yen, and 11.9% consists of the British pound. The rest of the dollar index comprises of a few other countries, but the composition is less than these three major countries. The majority of this index is weighted towards the euro, and it's integral to understand this currency to determine the price action of the dollar.

The euro sold off earlier in the year due to fears of Marine Le Pen winning the French election. Investors sold the currency due to the threats that she would ditch the euro. Once Macron built a strong lead over his opponent, FXE (the euro ETF) rallied hard in early April. Speculators jumped on the bandwagon and drove this close to 1.13.

The same speculators (non commercials) that were bearish earlier in the year are now net long 74,009 futures contracts. The opposite is true of the commercials as they are net short 91,005 contracts. Compared against the last six years, this represents an extreme level of short positions. The last time they were extremely net short, the euro traded around 1.50 in May of 2011. As the eurozone crisis emerged, the euro plummeted approximately 20% to 1.20 within the next year.

Although the commercial hedgers are extremely net short, this doesn't mean that the euro will plummet as it did six years ago. However, this means that there is a higher probability that the euro will correct, and hence, the dollar index should catch a bid. The dollar can also benefit if the 10-year and the 30-year bond sell off. With the Fed raising rates next week, this can definitely be the catalyst in propelling yields higher. If this occurs, the 10- and 30-year yield will remain above the 200-day moving average, which will lead the dollar higher.

There are several commentators discussing how the dollar will go lower this year. With the German elections coming up, momentum is on the side of Angela Merkel. Assuming she wins, the euro will rally to the upside as it did when Macron won. Although these pundits may be right regarding the dollar, the reality is that the smart money is aggressively short the euro. Assuming that the commercials are right, traders/investors may want to wait until the weak hands get flushed out this summer.

Supporting Documents

  1. Fed_watch_tool_06.10.2017.pdf

Disclosure: I am/we are short E MICRO EURO FUTURES.

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 have a bear call spread in the bond futures markets betting that interest rates will go higher. I have bullish and bearish positions in gold.