Curb Your Enthusiasm for the US Dollar
As one walks through the global financial markets forest there is nary a US Dollar bear to be seen. Abenomics has failed to stimulate the Japanese economy and the Eurozone is slipping closer toward deflation. At the same time, FED Hawks like Richard Fisher are squawking about raising US interest rates in the spring of 2015. This combination of factors has created a vast prairie for the dollar bulls to roam. But is the enthusiasm justified?
On Friday the US Bureau of Labor Statistics will release its monthly employment report and this data is sure to be scrutinized by investors and traders alike. Everyone is searching for the answer to this question: Has the US economy reached escape velocity?
The following chart is the monthly increase in Nonfarm payrolls and it illustrates that since 2011 job creation has been steady…but steady is a long way from acceleration.
In addition to fostering full employment, the FED is charged with maintaining stable prices a.k.a 2% inflation. One of the most important determinants of inflation is the expectation for higher or lower prices. More than anything else, inflation expectations have been shown to have the most influence on future inflation. It is for this reason that the FED (and private economists) watch market based inflation expectation data.
The following chart is the 5 year Break Even inflation rate on TIPs – this data point shows the markets assessment of future inflation.
Since early July 2014, inflation expectations have been falling to levels not seen in 2 years. Of course a strong dollar has weighed on commodities and a glut of US oil has created a benign inflationary environment. However, the direction of inflation expectations should give the FED pause. In the past falling inflation expectations have prompted bets on more QE.
If the FED is data dependent then nonfarm payrolls and inflation expectations suggest it should considering easing policy, not preparing to raise rates. Interestingly, at the same timethe data is pointing toward a disinflationary environment the US Dollar has staged one of the largest rallies in modern history.
Much of the rally in the US dollar has been the result of market expectations for other central banks to act – in particular the ECB is widely expected to launch sovereign QE and Japan continues to struggle under tax increases. The long term chart below shows that expectations of ECB and BoJ easing have pushed the dollar to an important inflection point.
The shorter term technical picture does not look much better for US dollar bulls. In the following daily chart I have included a regression channel – this is similar to Bollinger Bands and indicates when a market has reached an extreme distance from the mean. In the case of the US dollar index, it has moved 2 standard deviations from the mean – a scenario which is extremely rare and often marks a turning point.
But it’s not just the price that has reached extreme levels; sentiment is also at a level that has marked turning points. The commitment of traders report shows the net positions of speculators in the futures markets and can be used to determine bullish/bearish sentiment. The Euro dominates the Dollar Index with a 57.6% weight and thus analyzing the sentiment in Euro can give clues to broader dollar sentiment.
The chart above indicates that the net speculative positon in the Euro is short. In fact, speculators are the most short they have been since July 2012. What did the US dollar do against the Euro in the six months following July 2012? It fell 13%.
The Forest through the Trees
It is clear that the market cannot see the bears in the forest because it is focused on the central bank trees in the foreground. On Thursday the ECB meets and is expected to explain more about its QE plans. Moreover, on Friday the US employment report is expected to show an increase of 192k jobs. Of course the expectation of this news has been the catalyst for a stronger dollar… so what’s next?
The US dollar is setup for a huge disappointment sell-off if the ECB does not deliver or the employment report comes in weaker than expected. For my clients I have reduced exposure to the long dollar trade. While aggressive traders may be inclined to attempt a short, the prudent move is to step to the sidelines until the trees disappear.