Dollar Peak Appear To Be In. Time To Short UUP
Summary
- The U.S dollar index is dropping with stocks due to the significant increase in Coronavirus concerns.
- A likely drop in U.S rates will cause real-interest to decline below -1%.
- The U.S dollar and U.S equities have become increasingly correlated, signaling a drop in the dollar is bearish for equities.
- The current setup appears to make for a strong short opportunity in the dollar index.
One of the major trends facing markets over the past decade has been the strong U.S dollar. Due to either excessively low-interest rates or high inflation, international currencies have been depreciating. The problem has been so jarring that it has led to the collapse of numerous emerging market currencies weighed down by excessive U.S dollar-denominated external debt.
The strong dollar has been generally bearish for commodities and because overseas investors want to gain exposure to it, bullish for U.S stocks and bonds as means of gaining said exposure. This strength has even allowed the U.S Federal Reserve to print currency and effectively fund the fiscal deficit without causing depreciation. Put simply, if you want to know where stocks, bonds, and commodities are going, watch the dollar.
The main factors that have benefited the dollar lie in its transition into safe-haven status, largely replacing the Japanese Yen. This has been through low-to-moderate inflation and generally higher interest rates compared to other countries. Further, the U.S's large trade deficit and high international debt financing have allowed for greater internationalization.
As I'll show, these bullish factors are quickly turning into bearish ones. The Dollar has been at its long-term resistance for about six months and has been unable to break new highs. Indeed, there may be a great short-setup for the Invesco Dollar ETF (NYSEARCA:UUP).
A Closer Look at UUP
Invesco's UUP ETF tracks an index of other developed currencies including the Euro, Japanese Yen, British Pound, Canadian Dollar, and Swedish Krona. The fund allows investors who do not trade FX or futures directly to easily gain exposure to the FX market.
The fund has an AUM of $303M making it the most liquid dollar ETF and has options and short selling. Its short borrowing fee has dropped in recent months but is still slightly higher at 3%. Although, it does have a 79 bp expense ratio which is to the benefit of short-sellers.
As you can see below, the fund generally tracks the performance of the real-trade weighted dollar index which holds a few other currencies but has the same general fundamentals:
Data by YCharts
UUP has been unable to break above the $27 level since inception despite nearly doing so about 5 times. This goes to show just how strong resistance is at that level. I believe that the dollar is headed lower with UUP headed to at least $24 if not back to long-term support.
A Global Central Bank Race to the Bottom
If global central banks continue to lower interest rates further and further below inflation and pursue QE to try to stimulate a slowing economy, all currencies will depreciate to gold or other hard assets.
The "Dollar" does not exist as a standalone asset. It is simply an index of exchange rates of other currencies. Thus what matters is not U.S interest rates or inflation, but those figures relative to the other countries in the index.
As you can see below, there has actually been a global rise in inflation over the past few months in all of the countries in UUP:
Data by YCharts
While the Yuan is not part of UUP's index, China is the cornerstone of the global supply chain so inflation in China is likely to spread abroad. As you can see below, China's inflation rate is accelerating higher with a 1% increase in January during the beginning of mass-coronavirus Quarantines:
Data by YCharts
Put simply, inflation is on the rise. It may not be problematically high today, but this factor should be kept in mind because it is bearish for currencies and bonds.
While inflation is on the rise, interest rates are on the decline in the U.S to promote the economy. Of course, the further rates are below inflation the faster inflation will rise. As you can see below, U.S rates are declining while peers in UUP are being held steady:
Data by YCharts
As the U.S short-term rate declines so too do the carry-trade value of the U.S dollar. In fact, we can take this a step further and find real-interest rates by subtracting short-term rates from inflation. This is the expected purchasing power return one can expect when lending short-term (i.e savings account). The country with the highest real-rate should have the strongest currency.
Data by YCharts
As you can see, the U.S currently has the highest real-rate and, accordingly, is the strongest currency. That said, the U.S trend is very negative while it is clearly flat-to-positive in other developed countries. At this rate, the Yen will soon be a more profitable investment than the U.S dollar and likely the Pound thereafter. This fundamental trend confirms the technical signal on the dollar.
The Dollar-Financial Asset Problem
As I mentioned earlier, overseas investors have been the primary conduit pushing equities and bonds higher. Fundamentally, the U.S dollar should be negatively correlated to stocks and bonds. Bonds because higher interest rates boost the dollar and devalue bonds and stocks because a higher dollar hurts export GDP. However, the correlation between stocks and the dollar has trended into materially positive territory and the correlation between bonds and the dollar has risen to near-zero:
Data by YCharts
This shows that it is overseas investors that are likely the primary buyer of U.S financial assets and that they are buying with the intent of reducing exposure to their home currency.
However, now that the U.S dollar looks like it headed lower that trend may reverse. Indeed, this may make the bear market in U.S equities be significantly worse than globally. As you can see below, this may already be playing out as U.S equities have fallen significantly further than international peers:
Data by YCharts
The Bottom Line
Overall, it seems that the U.S dollar is headed lower. U.S inflation-adjusted interest rate still slightly higher than in peer countries, but the trend is clearly negative. Even more, the CME's interest-rate cut probability tool is currently pricing for an effectively 100% chance of a cut with a 50 bps cut most likely. If that occurs, the U.S real-interest rate will likely decline to at least -1.2% which will make it second-worst to the Euro.
The easiest way to make this trade is a short position on UUP though one could also go long the inverse dollar ETF (UDN). If the U.S dollar continues to fall, it will also likely promote international outflows of both U.S stocks and bonds which would exacerbate the ongoing sell-off and promote illiquidity.
Overall, I believe UUP is a "sell" with a target price of $24 with a year-end horizon.
This article was written by
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in UUP over 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.
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