Currencies: Dollar Rally Ending - Part II

Last week we covered Equities outlook, mainly focusing on S&P 500 from both short term and medium / long term. This week I have been following up on Currencies outlook in a two part post. The first part was posted at the start of the week (Article: Dollar Rally Ending - Part I), while the second will be posted today.

Introduction

The first part of the currencies post was mainly focused on easing of financial conditions in the Eurozone, which should remove any systematic risk in the banking sector for the time being, and with it also withdraw strong Dollar financing demand. On top of that, we can also concluded that the current US Dollar Index rally, mainly against the Euro and the Pound, 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. After looking at the price action this week, we can conclude that the Dollar ended up being even weaker, than when the first post was written on Monday.

Sentiment

The Trade Weighted Dollar Index has been moving up gradually during another saga of European problems. As I scout around the blog-sphere, almost every single investor is bullish on the US Dollar. It is amazing how much the mood has changed since May of last year. This is usually a signal of an up and coming top. It seems that a lot of investors are making the same old mistake - they are staring right at the DXY Dollar Index and saying that it has more room to move higher. Meanwhile, the Dollar itself is starting to fall hard against a large number of global currencies - refer to the first post (Article: Dollar Rally Ending - Part I).

It seems that global investors away from the Western countries are not behaving as stupidly as they were in 2008, when the Lehman Crisis made them all flee into the US Dollar. Reason I say "stupidly" is because the US Dollar is far far away from a safe haven. Having said that, every crisis since than has resulted in a smaller and smaller Dollar rally during the short squeeze. Fast forward to today, and I actually cannot believe how optimistic investors are on the Dollar, even though it is only a several percentage points away from the early 2008 panic low. In other words, we barley made any ground on the upside and yet every man and his dog are US Dollar bulls. This is a perfect "slope of hope" recipe for the Dollar to slide lower with optimism remaining high. So why is this happening?

Well it has a lot to do with the Euro, that is "out-smarting" investors perceptions. Currency investors seem to be "mesmerised" by European problems, that they have forgotten what they are getting themselves into. Since currencies are a relative asset class, unlike equities, when an investors sells the Euro, he is usually forced to buy the Dollar (these two currencies have most globe liquidity). The only problem with being a Euro bear is that the Dollar is even worse both fundamentally and technically - and yet we currently have historical record net short positions on the Euro.

Investor keep asking themselves: "how come the Euro is not lower with all these problems around?" The answer is simple: more and more investors are moving away from the US Dollar safe have and its allure of a reserve currency (which won't last forever); and are fleeing into other assets that hold value and protect purchasing power better than Federal Reserve paper. Real assets like real estate, precious metals, raw materials and even equities are adjusting to the upside as central banks print, print and print some more.

Moving back to the topic of timing the currency markets, we can see that the US Dollar optimism according to SentimenTrader's cumulative group of survey's is rather extreme. Historically, when optimists outnumber pessimists by 70% or more, the US Dollar is close to putting in a top. This is especially true if we get more than one reading in close time proximity, where the second reading comes right after the first like in late 2008, middle of 2010 and today.

On top of that, one asset class indicator is not enough. We need to see this type of consensus outlook and universal bullishness on the Dollar match with similar strength of pessimism on the Euro, Pound and some other currencies. While I already covered the Swiss Franc record bearish opinion few days ago, the above chart shows us that when the Euro optimists fall below 30%, the Euro almost always tends to put in a proper intermediate term bottom. One smart way of using sentiment is to make sure Commitment of Traders positions confirm the outlook of Public Opinion. Today's conditions definitely do, as Euro is the most hated asset right now.

Summary

Fundamentally, the Dollar is an awful currency. We are currently in a secular long term bear market, where this terribly flawed currency will eventually loose its reverse status. It is not a straight road down the hill and there will be major Dollar rallies along the way, but one of the main themes is to stay constantly bearish on the Dollar. When others are bearish with you, resist shorting the Dollar and even buy some calls on it, but when others are bullish on the currency like they are today, it is definitely time to open some shorts or add to your existing short positions.

As of this weeks price action, the Dollar strength is not broad anymore, while sentiment and technicals imply bearish outcomes lay ahead. Going long the Euro as a contrarian right around these levels might look like a smart move (maybe wait for a short term pullback or a retest of $1.26 level), but the Euro itself is also a sick currency. The same is true with the British Pound as well, so it is best to stay away from these three ugly sisters. Therefore, investors should short the US Dollar with other currencies that have better fundamentals, including the Swiss Franc, Australian Dollar, Korean Won, Canadian Dollar, Singapore Dollar, Norwegian Krone or Swedish Krona.

As a side note, there are now too many investors betting on further appreciation of the Japanese Yen, so i would be extra careful buying its heavily overvalued currency right around these levels as of today. That is not to say that the Yen cannot gain even more, but it is just a caution.