Currencies: Dollar Rally Ending - Part I

Last week we covered Equities outlook, mainly focusing on S&P 500 from both short term and medium / long term. This week I will touch up on Currencies outlook in a two part post. I hope you enjoy what I have to say here, because currently this is the market I am following the most (apart from Credit), as I will be making some investments in these assets very very soon.

Back in early September, I wrote an article about the reversal of the US Dollar downtrend (Article: Is The Dollar Rally Real?). The articles focus wasn't just on the European Union Crisis and the weakness of the Euro and the Pound, but looking at the broad currency picture from Commodity Currencies to BRIC and Emerging Markets Currencies. It is a great read, so I highly recommending going back and reading it before continuing. If time is short here is the summary:

"...the current Dollar strength is actually confirmed broadly throughout the world and not just by the relative weakness of the Euro and the Pound. Therefore, this lets us know there is a much greater chance that the Dollar will now stage a short to medium term rally. Those long the Dollar should take comfort in knowing that the majority of other currencies as well as precious metals look exhausted and ready to correct."

Fast forward to today, over four months since that article was written, and what happened was exec tally that. Globally, currencies and precious metals experienced strong corrections from September to December. However, what we have now is a reverse setup in my opinion. I think that the Dollar rally is now in its last inning. Apart from short term jerks or spikes due to EU problems in coming days or weeks, it is my opinion that the Dollar is in the process of forming a top. Therefore, personally I will be looking for opportunities to short the King Dollar around these levels and here is my reason why:

Dollar Funding Stress Easing

If you've read today's Chart Of The Day post, you would have noticed a chart showing how short term financing costs in both Spain and Italy have fallen dramatically since middle of November 2011. On top of that the chart above shows European Financial Stress is now easing too. This can also been seen by looking at the Euro Dollar 3 Month Swap Rate, which is now improving significantly since late November 2011. Therefore, we can conclude that open market US Dollar demand for debt financing by banking institutions is starting to ease. If the Dollar will not be rallying due to systematic bad news, than what other reason is there for the Dollar to rally?

Dollar Rally Is Not Broad

Bob Farrell was one wise investor and his rules should always be respected, followed and executed. At least I think so. Rule number 7 this gentlemen put forward was:

7. Markets are strongest when they are broad and weakest when they narrow. This is why breadth very important. Think of it as strength in numbers. Broad momentum is hard to stop.

While breadth is mainly applied to Equity Indices like S&P 500, the theory can be used in any asset class. Personally, I do not make decisions in the currency markets based on the US Dollar Index, like so many others investors. This is suicide, as the Euro and the Pound hold majority of the weighting and the index is definitely not a good broad measure of Dollar's strength.

So I have constructed my own Currency Board, which tracks European, Commodity, BRIC, Asian and other Emerging Market currencies. It is designed to give us a feel of weather the Dollar is strong - rising against majority of the global currencies; or if the Euro is weak - Dollar rising against Euro, Pound and few other selected currencies, but falling against other majors. Remember, when the Euro falls, it is very important to know weather the Dollar is strong across the board or if the Euro is just weak.

If we look at the Currency Board above, which is updated as of Friday's close, we can see that while the US Dollar made a new weekly gain against the Euro, Pound and few other European currencies, it struggled against a lot of other important currencies, including New Zealand Dollar, Brazilian Real, Indian Rupee, Mexican Peso and Polish Zloty.

CNBC and Bloomberg were portraying S&P downgrade of France as a price melt down and yet the Dollar only gained against 9 out of 24 major currencies around the world. Furthermore, the Euro has been in a free fall over the last month or even longer, as it has closed down six straight weeks in the row. Having said that, majority of Commodity currencies, Asian currencies and GEM currencies have actually gained against the Dollar in the same time frame. Now... that is not a broad measure of strength, is it?

Another way of looking at this is from a technical perspective. You would have noticed from all the media reports that the Euro sank to a new 52 week low on Friday's bad news from the S&P downgrade. Euro Crisis is now on front pages of almost every single global newspaper in the world. So it makes sense for the US Dollar to also be making 52 week high across the board right?

The chart above shows that this type of so called "Dollar strength" is not confirmed against other currencies around the world. We can see that the Real, Ruble, Won and Peso have not confirm this move. However I could have taken any one of the following currencies and included them into the chart as well: Aussie & Kiwi Dollars, Japanese Yen, Canadian Dollar, Singapore Dollar, Taiwan Dollar, Indonesian Rupiah, Indian Rupee, Chilean Peso, Chinese Yuan, South African Rand, Turkish Lira and Polish Zloty have not confirmed the move either (and the list goes on). Don't be fooled by the US Dollar Index because... that is not a broad measure of strength, is it?

Summary

In this first part of a two part post, we can see that financial conditions in the Eurozone are easing. This might still be subject to slight change with potential turbulence over coming days or weeks, but with ECB expanding its balance sheet it is pretty safe to say that the can has been kicked down the road again. This removes systematic risk in the banking sector for awhile and with it strong Dollar demand. So what does this mean? It pretty much means that the Dollar will return back to trading on its fundamentals - a terribly flawed currency, which is even worse than the Euro.

On top of that, we can also conclude that the current US Dollar Index rally, mainly against the Euro and the Pound, from the last week as well as from the last month, is not confirmed globally in a broad Currency Board measure. It is also not confirmed by looking at simple technicals where the US Dollar is failing to make new highs against almost every currency apart from a few European ones.

All of this leads me to conclude that the Dollar rally is suspect and that the the Euro weakness is coming to an end. In part two, which will be written later in the week, we will be focusing on sentiment and investor positioning. Time to turn contrarian on all this bad news around us so stay tuned!