Back in April 2008, the USDX hit an all-time closing low. And since the USDX has been around
since March 1973, all-time is a big
deal. Since its secular bear started in July 2001, this leading currency had
fallen a mind-blowing 41%! You
could hardly even give dollars away back then, central banks were trying to
diversify away from them.
Meanwhile the euro, which nearly everyone assumes is going to zero
today, was trading near $1.60.
Throughout the first half of 2008, the USDX lingered near all-time
lows.
Then in July 2008, something unprecedented drove great fear. The once invulnerable US
mortgage giants Fannie Mae and Freddie Mac teetered on the edge of bankruptcy. In a single month their stocks had
plummeted 72% and 78%! Large
investors around the world who owned trillions
of dollars worth of mortgage-backed bonds watched nervously. Would they get their principal back if
the GSEs failed? Rather than holding
and hoping, they rushed to sell GSE bonds and buy much-safer US Treasuries
instead.
Before this GSE crisis that cascaded into a full-blown bond panic
emerged, the USDX was languishing at just 0.5% over its all-time low in
mid-July 2008. But bond-panic
fear drove a massive dollar rally as flight capital rushed to the relative
safety of US Treasuries. Of
course foreign investors had to buy dollars first. After bond fears started to abate in
early September, the USDX quickly collapsed back down.
But then the infamous stock panic slammed into already-fragile global
markets. At its climax in October
2008, the SPX had plummeted 30% in a
month! It was effectively
unprecedented, the first true panic in 101 years. This
kicked fear into overdrive, spawning another utterly massive exodus of scared
capital out of global stock markets and into cash (US dollars) and US
Treasuries. As a result of this
stock panic following the bond panic, the USDX skyrocketed 22.6% higher in 4
months. This was the biggest and
fastest rally ever witnessed over such a span in this index’s entire
history!
I called this “the panic trade” at the time. Sell everything, buy dollars and
Treasuries. It crushed
commodities, which are heavily dependent on dollar levels, and commodities
stocks. And even though the euro got massacred by this epic USDX rally, it wasn’t the euro
that was driving the dollar buying.
It was raw fear, a stock-panic-driven flight from risky assets around
the world and into safe-haven US dollars. At least cash positions would preserve
principal through the panic maelstrom.
Note above that the USDX topped on the
exact days the SPX bottomed!
In fact, leading into the SPX lows in October 2008, November 2008, and
March 2009, the dollar’s negative correlation with the US stock markets
was uncanny. Respectively the
USDX hit new highs when the SPX hit new lows on 5 days, 2 days, and 5 days
over these three major stock-market bottoms. The US dollar was totally at the mercy
of the stock markets’ fortunes, only surging when they were
exceptionally weak.
If you were paying attention during that panic span, and who
wasn’t, you well remember that the US dollar was hardly ever
discussed. All discourse was
dominated by the sorry state of the US stock markets and the resulting
economic fears that we were entering a new full-blown depression. Pessimistic stock-market psychology
drowned out everything else over
that panic span, and the dollar was driven to trade in lockstep opposition to
the SPX.
In this chart, the visual evidence of this inverse correlation is
irrefutable. Not only were USDX
highs exactly synchronized with SPX lows, but in periods when the SPX was
weak the dollar was strong and vice versa. The panic trade drove an
incredibly-tight inverse correlation.
In fact, from mid-July 2008 when all this fear-driven dollar-buying
action started to early-June 2009, the statistical negative correlation was
so high that the USDX and SPX sported an r-square of 79.8%.
In other words, 80% of all the daily trading action of the US Dollar
Index over this wild panic span was directly explainable mathematically by
the SPX’s own. Sure, there
were exceptions from time to time when the dollar’s own drivers
temporarily overrode the SPX’s dominating psychological influence. In March 2009 for example, the USDX
plunged and then recovered on news the goofy US Fed was starting to monetize
US debt. But in general, the
dollar action that awoke it from its bear slumber was utterly dominated by
the SPX.
A month ago I wrote an essay chronicling the euro action over this panic time frame. Naturally when the dollar was strong
the euro was weak and vice versa.
But the causality was crystal-clear. It wasn’t Europe fears that were
driving US stock-market selling, but US mortgage-market fears. And it wasn’t euro weakness that
was driving the unprecedented dollar strength, but the surging dollar that
was hammering the euro.
The panic trade resulted from stock-market fear driving aggressive
safe-haven dollar buying. The
euro was simply collateral damage.
This history is beyond argument, I doubt anyone could dispute it. And it is incredibly relevant today
because I suspect what we’ve seen in 2010 is a resumption of that
famous panic trade. This year,
just like during the panic, falling stock markets are generating fear leading
to dollar buying. And the falling
euro is the effect, not the cause
as most traders now assume.
The strong inverse correlation between the USDX and SPX persisted into
the summer of 2009. While the US
stock markets rallied powerfully between April and November, the supposedly
mighty dollar sold off relentlessly.
In fact, by late November 2009 it grew heavily-oversold. It had fallen to 0.92x its 200-day
moving average, a level in the past from which major bear rallies erupted.
And another big bear rally was certainly due in late 2009, as I warned
our subscribers about in early November.
Provocatively at those oversold late-2009 lows, the USDX was only 3.5%
above its ultra-weak July 2008 levels where its stock-panic-driven rally
started. Over this same span, the
SPX was 8.6% lower. Heck, last
November the USDX was only 4.0% above its all-time low from April 2008! The strong-dollar crowd so vocal today
conveniently forgets how pathetic the USDX looked for most of 2009 before its
necessary and healthy bear rally erupted. Without stock-market selling, the
dollar couldn’t catch a bid!
That sharp bear rally in December 2009 was one of those periodic
events where the USDX decoupled from the SPX to once again follow its own
sentiment drivers. But the dollar
quickly worked off its oversold condition in a matter of weeks and soon
started trending lower again as the SPX ground higher from mid-December to
mid-January. The USDX
didn’t start surging again until the SPX started retreating in late
January in what would become its biggest pullback (8.1%) of its entire cyclical bull to that point.
In early February 2010 when the SPX bounced, the USDX bear rally
promptly stalled as expected. If
the SPX was driving the dollar most of the time, and it clearly was as
we’ve seen in these charts, then flight capital shouldn’t flood
into US dollars unless the stock markets were weak. And indeed as the SPX surged between
early February and late April, the USDX was largely flat and grinding
sideways.
Why wasn’t the dollar weak with the SPX strong? This February-to-April span saw the
rise of the totally irrational euro-to-zero fears. The
vast majority of traders refused to see the dollar action within the past
couple years’ context and instead arbitrarily assigned the euro
primary-driver status. And if you
remember how overpowering the Europe woes were for market psychology between
February and April, the dollar’s flatness is very damning. If the USDX couldn’t rally in
that perfect environment, can it even be in a bull?
And then in late April, the SPX started topping and rolling over. In early May the Flash Crash erupted,
sparking widespread fear. The SPX
was plunging in its biggest and first true correction of this entire cyclical
bull. Suspiciously, the USDX
didn’t start surging again until
the SPX started plunging. It
was a minor echo of the panic trade, sell everything else to buy dollars and
US Treasuries.
Over the SPX’s 6-week correction span, it fell 13.7% while the
USDX rocketed 8.7% higher. Yet
again the USDX peaked (near March 2009 panic highs no less) on the very day the SPX bottomed in
early June! Interestingly the
negative correlation of the USDX and SPX over this correction was so powerful
that they ran an r-square of 81%.
This is very close to what we saw earlier during the stock panic. The primary driver of the USDX was not
the flagging euro, but the plunging US stock markets. This has been the case for nearly all of
2010.
Carefully examine the USDX’s trading action so far this year in
this chart. Note that nearly all
its gains this year, on the order of 9/10ths, occurred in just two short
spurts. The first coincided
nearly exactly with the sharp SPX pullback of late January and early February
and the second nearly exactly with the sharp SPX correction between late
April and early June.
2010’s vaunted dollar rally is nothing more than a temporary
resurgence of 2008’s tired panic trade! The dollar can only rally when the SPX
is falling!
So the SPX is driving the USDX, what’s the big deal? This contrarian perspective on
prevailing causality radically changes
our trading perspective going forward.
Consider the very-different outlooks driven by a euro-centric or
SPX-centric worldview, especially if you are a commodities-stock speculator
or investor.
If the conventional euro-centric worldview is correct, the US dollar
could rally for a long time to come since Europe’s socialism-spawned
debt problems aren’t going away anytime soon. A higher dollar means lower commodities
prices, and lower commodities prices mean weaker profits and hence lower
stock prices for commodities producers.
The prevailing structural perspective on a Europe-driven dollar rally
is actually pretty darned bearish for commodities stocks in the foreseeable
future. And this view also
assumes Europe is driving the US stock markets lower, so it is bearish for
the SPX as well.
But if the SPX retreats are the ultimate driver of the dollar’s
strength, it changes everything.
As soon as today’s SPX cyclical-bull-within-a-secular-bear
resumes, the dollar will start selling off again as flight capital exits
dollars and Treasuries and returns to the stock markets. A falling dollar will drive the euro
higher, seriously reducing European financial concerns plaguing market
psychology. Commodities prices
will surge on the dollar weakness, driving big gains in commodities
stocks. And of course all sectors
will enjoy a nice boost as the broader stock markets rally.
Pretty wild, eh? Your
perspective on what is driving the US dollar’s rally this year can
change your near-term worldview from bearish to bullish. Trading strategies, especially for
commodities stocks, shift 180 degrees depending on what is driving the
dollar. And as I suspect
you’ll agree if you really take the time to digest the charts in this
essay, it is the SPX that is driving the USDX. Just like we saw during the stock panic.
At Zeal, we don’t accept conventional wisdom just because most
people believe it. We carefully
study interactions between major markets to understand true causality. In order to be a contrarian and buy
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The bottom line is this year’s US dollar rally has been driven
almost exclusively by stock-market weakness. This is a resurgent echo of the panic
trade, sell everything to buy US dollars and US Treasuries whenever the stock
markets are sliding and generating fear.
The moment stock selling abates, the dollar promptly starts falling
(or rarely drifting sideways). Stocks’
fortunes are the key to the dollar.
This widely-ignored causality has huge implications for traders. As stock markets bounce and flight
capital emerges from hiding in the dollar and Treasuries, the dollar will
fall rapidly. This will drive big
surges in commodities prices since the world’s raw materials are still
primarily priced in US dollars.
And of course higher commodities prices will lead to higher profits,
and hence stock prices, for commodities producers.
Adam Hamilton, CPA
Zealllc.com
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