3 Things That Could Reverse the Dollar Rally

Includes: ERE, ERO, EU, FXE, UDN, UUP
by: Kathy Lien

With the US dollar hitting a six month high against the Euro on a intraday basis, everyone in the financial markets are talking about how much further the dollar can rise. However not as many people have entertained the notion of what could trigger a major reversal in the US dollar. Since July, the greenback has risen 8 percent against the Euro and 7 percent against the British pound and in all likelihood, the dollar rally will continue. However a reversal in the US dollar could be triggered by factors that are more realistic than most traders may have expected and the longer the current rally continues, the greater the risk of a reversal. There are 3 things that I believe could trigger a brutal correction in the dollar including a turn in sentiment, a rise in oil prices and a big US bank failure.

The currency market is trending by nature and we have seen the strength of these trends over the past month, but it is important to realize that just as quickly as market sentiment has turned dollar positive, it can also turn dollar negative. All the currency markets needs is one big shocker and the EUR/USD could be headed back towards 1.50.

1. Sentiment Turns – USD long positions on IMM hit 14 month high

For the third week in a row, currency speculators have boosted their bets on a further rise in the U.S. dollar. Long positions according to the Commitment of Traders report has hit a 14th month high and whenever positions get this stretched, it is a red flag that calls for turn right around the corner. The logic is that with everyone who wants to be long is probably already long and as a result, there are only a few buyers left in the market.

2. Oil Prices Begin to Turn Higher

One of the primary reasons why the US dollar has rallied so dramatically is oil prices. Although it is oftentimes difficult to tell which is leading the other – the currency or the commodity, there is no doubt that the correlation is strong. Since its highs in July, oil prices have fallen 24 percent but with Hurricane season just beginning, anything close to Hurricane Rita in 2005 could send oil prices back higher. Still, I do not expect new highs in oil prices – they have peaked and any move would probably only take prices back up to $125 - $130 a barrel. We are already seeing this dynamic play out today as the rise in oil prices triggers a sharp rally in the EUR/USD.

3. A Big US Bank Failure

With the one year anniversary of the subprime crisis looming, the financial sector is back in focus – unfortunately for all of the wrong reasons. The markets are not celebrating the recovery in the financial markets but are instead focusing on fresh worries. Fannie Mae and Freddie Mac are in big trouble – their shares have plunged leading to talk about nationalization or a big bailout by the US government. Kenneth Rogoff, a former IMF Chief Economist is warning of a big bank failure ahead. Could it be Lehman Brothers who is rumored to be looking to sell their investment management business? No bank would sell such a high value asset if they were not desperate for cash. Also, SageCrest a US hedge fund who once had as much as $950 million under management also filed for bankruptcy protection today. Trouble is brewing in the financial sector and so far we have only seen a third of the writedowns that Nouriel Roubini aka “Mr. Doom” has previously predicted. Although bank failures have been far less in this cycle than in the past (8 so far), a big failure could lead to sharp sell-off of US investments and in turn, the US dollar.
Dollar Rally to Slow

I still believe that the US dollar is headed for more gains, but I expect the rally to slow. Other than producer prices, we do not have any major US data this week – only the Philly Fed index and leading indicators are on the calendar. Bernanke will be speaking about Financial Stability on Friday, but with no questions expected, the central bank head will probably stick to topic. As a result, this is prime time for a correction in the US dollar, but don’t expect this correction to last because the problems abroad in the Eurozone and the UK are only beginning. A move in the EUR/USD below 1.40 is still far more likely than a new high.