The incessant jaw-boning by western central bankers continues to produce market confusion. But when the dust settles on the ECB’s Forum on Central Banking in Sintra, Portugal it will look pretty clear that Wednesday morning’s volatility across all markets marked the beginnings of a bottom in the U.S. dollar (UUP).
Bank of England chief Mark Carney’s comments about withdrawing stimulus sent the British Pound (FXB) soaring which, in turn, sent markets crazy. The euro (FXE) attempted a move to $1.14, the Canadian dollar (FXC) rallied to challenge $1.30 while Gold (GLD) attempt to break through $1255 was met with risk-on selling and flash crashed back to $1249 before recovering its footing.
This all looks dollar negative, I know. And it is, for now. But, it’s all just talk.
The most interesting development came up in the U.S. Treasury (TLT) market. For months, the yield curve has been flattening as the market kept trying to tell the Fed to stop raising rates.
Janet Yellen continues to be scared of being blamed for creating a bubble in equities. With the Dow Jones Industrials (DIA) continuing to push higher, the Fed is more determined than ever to prick what it feels is a bubble. Carney’s statement sent the Dow soaring as the market rotated out of at-risk sovereign debt and into U.S. equities.
But, with a hawkish tone set by all of the central bankers this week, it finally began to dawn on traders that, regardless, of the data, the Fed is serious about normalizing its balance sheet.
Looking at the 2/10 spread – the difference between 2-year and 10-year U.S. Treasury rates – we’ve got what looks like a double-bottom around 0.79% and a trend change, which began on Tuesday and followed through strongly on Wednesday.
I don’t care what kind of technician you are, that’s a reversal signal. The question now becomes: is it important enough to indicate a major shift in market action? This spread bottomed the day of the Fed rate hike. It re-tested that level a few days later.
Now, it’s moving higher as the market begins to think shorter term to raise dollar liquidity if the Bank of England is serious about ending QE, while, at the same time, Mario Draghi at the ECB wants to change course but can’t stop buying sovereign debt or those markets will implode.
Neither the euro-zone nor the U.K. economies can handle higher rates. Draghi hinted at removing his ‘put’ from the market and his comments had to be walked back the next day.
A widening U.S. 2/10 spread will put upward pressure on the dollar as domestic credit conditions tighten. Capital has been flowing into Europe post-French elections and Canada thanks to good, but, in my view, unsustainable GDP numbers associated with frothy housing conditions in major markets like Vancouver and Toronto.
That trend will reverse course the longer the euro remains over-valued. Moreover, we’re seeing topping action in the Chinese Yuan. And that will have the effect of stemming the outflow of capital from China and into markets like Canada.
The longer the dollar weakens while the Fed raises interest rates the more the global debt and currency markets look off-side to me. It’s not like there has been an end to foreign owned dollar-denominated debt. So, there has been no incentive to stop loading up on dollar debt.
This is the overhang that is waiting for any tremor in foreign debt and currency markets. No discussion of the U.S. dollar is complete without taking into consideration the mountain of foreign-owned non-bank corporate debt denominated in dollars out there (see chart above).
That mountain rises in value every time the dollar rises. The massive dollar rally in the wake of Donald Trump’s election put that at risk. This is why there has been a concerted effort in 2017 to undo the breakout on the USDX by the central banks by talking up the euro and emerging markets while we had a six-month correction in the dollar.
So, with these moves is this the beginning of a bear market for the dollar or just a correction within the larger bull-market trend?
Looking at the quarterly chart you can see we are perilously close to a quarterly close that would signify a bearish reversal on the USDX. Q2 has been a bloodbath for the dollar, but, as yet, it is not technically significant.
A close on Friday below the Q4 2016 low of 95.39 would signal that the selling isn’t over. And we are dangerously close to that breakdown now. But, if Wednesday was our ‘peak central-banker’ moment then this is the kind of climax selling in the dollar and short-covering in reciprocal markets that mark bottoms.
I remain unconvinced this dollar bear market is real. Gold and Silver (SLV) refuse to put on real gains, meandering around weakly while the dollar collapses. And, while there may be some upside left in the euro, nothing has fundamentally changed between the policy directions of the Fed and the ECB.
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.