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. The outcome of the JUN 20 FOMC meeting is particularly key to this view.
VIRTUAL PORTFOLIO: Long the U.S. Dollar (UUP).
On OCT 21, 2011, we published a note titled, “ARE YOU BULLISH ENOUGH ON KING DOLLAR?”; the conclusion of that note is identical to the conclusion above (w/ the exception of the FOMC callout).
- Since then, the US Dollar Index is up roughly +7.5% and the 19-commodity CRB Index is down about -13%;
- Turning to domestic equity markets, the XLE and XLB have underperformed the S&P 500 by -1,271bps and -370bps, respectively over that duration;
- Turning to global equity markets, the MSCI Energy and MSCI Basic Materials Indices have underperformed the MSCI World Index by -812bps and -745bps, respectively, over that duration;
- Turning to emerging markets, the MSCI EM Energy and MSCI EM Basic Materials Indices have underperformed the MSCI EM Index by -740bps and -774bps, respectively, over that duration; and
- The JPM EM FX Index is down roughly -4.3%, with notable currencies like the Brazilian real and the Indian rupee down about -13.7% and -10%, respectively.
As we often say: “Get the US Dollar right and you’ll get a lot of other things right.”
Upon hearing a financial market pundit warn about the overstretched nature of the EUR short position in the speculative community (213k contracts net short is an all-time extreme in either direction), we took an opportunity this morning to refresh our DXY speculative positioning analysis. The results were quite interesting indeed.
Jumping back to the DXY, the following chart highlights the point we just made regarding the “interesting” nature of what is taking place in the non-commercial futures and options markets. Specifically, we’ve just witnessed three consecutive, indistinguishable peaks in the DXY net long positioning – an event that has not yet occurred in the data (since MAR ’95) until the latest reported data point.
In the OCT iteration of this analysis, we found that each peak or trough in the speculative position of the DXY (as measured by futures and options contracts) had a corresponding trough or peak position, as well as a corresponding peak or trough in the US Dollar Index – each on its own lag. Perhaps more importantly, we found that the move off the bottom in speculative positioning tended to produce an equivalent or greater move off the bottom in the DXY from a standard deviation perspective.
This really highlights the peculiar nature of having three consecutive extremes in net long positioning, w/ no corresponding extreme in net short positioning. Perhaps more importantly, as the above table highlights, the DXY trough-to-peak move has lagged the trough-to-peak move in speculative positioning by ~1 standard deviation in each of the first two peaks.
The key takeaway here is that if that analysis still holds true – particularly the lag between a peak/trough in the speculative positioning and a commensurate peak/trough in the DXY from a standard deviation perspective – we could be looking at higher-highs in the DXY over the intermediate term TREND (see above table for scenario-analyzed timing and magnitude).
As we’ve shown in much of our research over the last six months, a narrowing spread between Obama and Romney is fundamentally supportive of this view – particularly as we draw closer to the election because we think that will force the Fed into a political box; as is an escalation of Europe’s Sovereign Debt Dichotomy. Key catalysts on this front include:
- JUN 14: Eurogroup Meeting
- JUN 15: G20 Summit of Finance Ministers
- JUN 17: Greece – probable date for next general election
- JUN 18-19: G20 Summit in Los Cabos, Mexico
- JUN 19-20: FOMC Meeting; Fed releases its revised economic projections***
- JUN 20-21: Eurogroup Meeting; Ecofin Meeting in Luxembourg
- JUN 28-29: EU Summit in Brussels, aim to formally sign off on growth proposals; EC meets to discuss Institutional Affairs
- JUL 5: ECB governing council meeting
- JUL 11: Minutes from the FOMC’s JUN 19-20 meeting
- JUL 19: ECB governing council meeting
- JUL 31-AUG 1: FOMC Meeting***
All-told, if consensus doesn’t get what it wants from the Fed in the immediate-term (i.e. a bailout of global stock and commodity markets), we are likely to see continued USD strength vs. peer currencies over the intermediate-term TREND. This would have potentially dour implications on the near-term returns of various asset classes (trailing 2MO correlations to the DXY):
- S&P 500: -0.92
- EuroStoxx 600: -0.94
- MSCI World Index: -0.94
- CRB Index: -0.93
- US Junk Bond Yields: +0.83
As always, the Correlation Risk will eventually burn off, allowing for alpha generation to resurface in dynamic asset allocation strategies. Until that happens, however, expect the USD to continue to be the dominant driver of Global Macro beta (i.e. the directionality of various asset classes).