Conclusion: Our analysis of derivative positioning and its impact on the FX spot market as a leading indicator strongly suggests that it likely won’t pay to fade consensus as it relates to being bullish on the U.S. Dollar over the intermediate-term TREND. Further, the math supports our fundamental stance of being bearish on things that are inversely correlated to the Greenback over the same duration.
Position: Long the U.S. Dollar (UUP); Short the Euro (FXE).
Themes at Play: King Dollar; Deflating the Inflation; Correlation Crash; Eurocrat Bazooka.
Much to-do is being made about how crowded the Euro-short position is and we agree that this is an acute immediate-term risk to manage. As it relates to the amount of open interest in the futures and options market, those speculators large enough to meet the minimum reporting requirements of the CFTC are net short the Euro by a total -69.8k contracts as of the latest reporting period (Oct 11). Just off of the late-September highs in short interest of -79.6k and 1.8x standard deviations below the 5yr average of +17.1 net long, it’s pretty clear that this is a fairly one-sided trade.
Does it pay to fade the market here? The short answer is “no”. As indicated by both our fundamental outlook and the marked-to-market positioning within our Virtual Portfolio, we expect consensus to remain right on this currency play over the intermediate term TREND.
Speaking of trends, one of the reasons we rely heavily on the foreign exchange as a real-time leading indicator of both market prices and economic fundamentals is because of its sheer size ($4 trillion in daily turnover = the world’s largest mkt.) and its reflexive nature. To the former point, we are of the belief that an investor’s greatest source of conviction lies with where he plays his chips. To the latter point, the highly-levered nature of many FX market transactions (in some cases 250:1) causes the basic risk management of gains and losses to perpetuate any given pattern of trading. Moreover, currency pairs trade on their relative economic fundamentals – data that tends to be more glacial and self-sustaining in nature.
Turning to King Dollar specifically, we continue to believe strength in America’s currency will be supported over the intermediate term by a combination of three factors:
- Subsequent to the left-leaning Mario Draghi assuming control of the ECB next month, we expect to see a rate-cutting and/or money-printing cycle out of the Eurozone over the intermediate term as Eurozone economic growth continues to slow and exacerbate the region’s sovereign fiscal metrics (Euro = 57.6% of the DXY basket).
- As reported inflation peaks in 3Q/4Q and trends down (albeit slowly in some cases), a cycle of monetary easing and fiscal policy relaxation is likely to sweep across emerging market economies. For early examples of this phenomenon, refer to the recent Brazilian, Indonesian, and Turkish rate cuts; Singapore’s FX adjustment; and Filipino and Malaysian stimulus measures.
- While Obama/Bernanke/Geithner will certainly be tempted to incrementally ease both monetary and fiscal policy in the U.S., we think both mounting political pressure from the right (i.e.: voting down incremental stimulus and publicly speaking against the Fed) and sticky reported inflation (particularly “core” inflation) will keep this Keynesian trio in a box – at least for the time being. Obviously the risk of Bernanke forcefully imposing more of his academic dogma unto the markets and the U.S. economy is likely to remain a key source of both consternation and volatility in the FX markets going forward.
We’ve been harping on each of these themes in various reports and presentations over the past couple of quarters, so we’ll leave it there for the sake of brevity. Email us if you’d like us to follow up with more details regarding any of these points.
Is a Big Appreciation in the U.S. Dollar Index Forthcoming?
Performing a similar futures + options analysis on the U.S. Dollar Index as we did with the Euro above yields a surprisingly more interesting conclusion. Interestingly enough, open interest from large speculators reached +47k contracts net long as of the latest reporting period (Oct 11) – the highest on record, which dates back to 1995.
Surely, we must fade this consensus positing?
A resounding “no” would be our answer here. Analyzing the open interest with the U.S. Dollar Index’s spot price provides a shocking conclusion: the derivative positioning tends to lead the action in the spot market by 2-6 months – particularly when pushed to an extreme in either direction.
Given that the most recent reporting shows the net long positioning at the highest on record, we would expect to see a pronounced move to the upside in the U.S. Dollar Index’s spot price over the intermediate term. The current futures + options positing registers as a +3.9x standard deviation move “off the lows”. A commensurate move in both size and historical median duration in the U.S. dollar index from April’s cycle-low of $72.93 would put the DXY at $89.30 by mid-February.
The principles of chaos theory driving our research at the most basic level would never allow us to subscribe to the Old Wall Street model of throwing out a price target and a target date for any market (let alone the #1 factor in our Global Macro model); we do, however, think the above scenario analysis is one of many risks to at least respect as probable. Moreover, a sustained and measured breakout in the U.S. Dollar Index may prove particularly bearish for asset classes inversely correlated to the DXY (immediate-term TRADE duration regressions):
- Brent Crude Oil: r² = 0.90;
- Corn: r² = 0.82;
- CRB Index: r² = 0.87; and
- S&P 500: r² = 0.92.
Conversely, it may prove particularly bullish for things positively correlated to the DXY, like:
- CBOE SPX Volatility Index (VIX): r² = 0.75; and
- U.S. Junk Bond Yields: r² = 0.93 (bankruptcy cycle?).
As with all of our research, the purpose is not to fear monger or be alarmist. Rather, we hope we are equipping you with the differentiated analysis that allows you to both manage risk and preserve your client’s hard-earned capital throughout volatile times like these. As always, we’re here if you have any follow up questions.
Have a great weekend with your respective families,