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Conclusion: The U.S. Dollar remains the dominant factor in our 27-factor Global Macro model and it continues to signal to us to be outright short or have extremely low levels of exposure to commodities and emerging market currencies over the intermediate term.

 

Positions: Long the U.S. Dollar (UUP).

Given recent developments across the global foreign exchange market, we thought we’d take the time to briefly provide you with our updated thoughts as it relates to managing the FX risk on your screens. Having a call on this asset class (particularly vs. the USD) is crucial to determining the associated costs of entering, exiting, and hedging one’s exposure to assets denominated in foreign currencies – including the FX impact on cross-border investment returns.

As it stands now, we are currently bullish on the U.S. Dollar and long it via the ETF “UUP” in our Virtual Portfolio (having been accurate on 22 of the past 23 positions). This is a meaningful stance we have taken and is also underscored by our recent decision to reduce our exposure to commodities within our Dynamic Asset Allocation to ZERO percent.

For context, we’ve only been this bullish on the U.S. Dollar twice since our firm’s inception just over three years ago: 2Q08 and 1Q10. Though no two periods of economic history are alike, the chart below provides useful reference points for what happened to the commodity complex after prior episodes of Hedgeye USD-bullishness:

Global FX Update - 1

As a corollary to the USD-breakout, commodities as an asset class (as measured by the CRB Index) remain broken across our TREND and TAIL durations. We’ve been calling for this Deflating the Inflation and that outlook was the primary reason we were on time in getting out of the long side of things like crude oil and energy stocks back in 2Q11. Regarding crude oil specifically, earlier today we initiated a short position in Brent (ETF: “BNO”) in our Virtual Portfolio.

Global FX Update - 2

Bernanke’s Box and our call for Europe to ease monetary policy in the latter part of the year remain the two primary reasons we have called for and seen recent U.S. Dollar strength:

“Slowing growth in the Eurozone will have the FX market pricing in less and less hawkishness out of the ECB relative to the Fed on a go-forward basis (don’t forget that the socialist Mario Draghi takes over in November and the Europeans have a full 125bps of potential interest rates to cut). EUR bearishness is USD bullish (57.6% of DXY basket).”

- “Emerging vs. Developed Markets: Aggressively Framing Up the Debate”, June 24

“In aggregate, CPI readings should continue to keep the Federal Reserve in a box as it relates to implementing incremental easing.”

- “Inflation?  Deflation?  Reflation?  Nope, Jobless Stagflation”, August 18

“Our view of incremental easing remains that the Federal Reserve will be in a proverbial box in terms of incremental easing until at least the end of 2011, if not well into 2012. The primary reason for this is simply that the data will not support further easing… inflation was running at much lower levels, largely below 1%, when the first two rounds of quantitative easing were implemented. Currently, this measure of inflation is north of 3% and set to remain at that level through the next couple of quarters based our models.”

- “The Fed Remains in a Box”, August 26

Above all, the U.S. Dollar’s quantitative setup is quite bullish and price remains the dominant factor in our Global Macro framework:

Global FX Update - 3

Of course, Christine Lagarde and the IMF’s soon-to-be-announced La Bazooka (see: today’s Early Look) could work to strengthen the Euro for a TRADE, but the prevailing quantitative setup (bearish TAIL) remains the trend. We covered our Euro short (ETF: “FXE”) yesterday in anticipation of such immediate-term price action, especially given how crowded this trade is. In fact, as of the most recent reporting period, the EUR/USD garnered the highest number of bearish wagers by hedge funds and other large speculators since July ‘10 (54,459 net-short contracts on Sept 13 vs. 2,539 net-long contracts on Aug 23).

Global FX Update - 4

Of course, being bullish on the dollar implicitly implies that we’re bearish on most emerging market currencies and that is a key risk to monitor as it relates to the performance of your foreign currency-denominated assets. In this space, a general shift towards dovish monetary policy, massive external debt issuance in recent years, and a general repatriation of US dollars are all combining to put downward pressure on the exchange rates of these economies:

Global FX Update - 5

For the sake of brevity, we won’t go into further detail on this topic now; we have, however, put together a long list of detailed notes and data points we’ve been sending to clients on a one-off basis as it relates to the rising external debt burdens and the recent “flows” out of emerging market (and European) assets and [perhaps] into liquid, large-cap U.S. equities – which have been largely outperforming much of world on a quarter-to-date basis. Email us if you’d like us to follow up with you directly.

The U.S. Dollar remains the dominant factor in our 27-factor Global Macro model and it continues to signal to us to be outright short or have extremely low levels of exposure to commodities and emerging market currencies over the intermediate term.

Darius Dale

Analyst