Currencies: Economy Could Disappoint & Weaken The Dollar

Note: This article has now been slightly updated, since its original version was posted yesterday.

A quick update on the state of currency markets, economic data and investor positioning. On the weekend, instead of doing a Global Macro Summary, I will be discussing the recent crash in the Japanese Yen and seeing weather or not it represents a buying opportunity.

Federal Reserve vs Economic Data

Since the good jobs data surprised majority of us traders, economists and fund manager, the market itself through the help of media, is now in speculation mode that additional Federal Reserve stimulus will not be needed. In other words, the market is acting like QE3 might be off the table. Ben Bernanke disagrees, sort of. He has made it clear that while the US economy is improving in the short term, QE3 option still remains on the table if things were to turn for the worse. The fact that it is not going to happen as early as some thought, has disappointed investors in many asset classes.

These investors, or for a better lack of a word junkies, who seem to react to stimulus a.k.a. money printing news, similar to that of a junkie discussing a topic of more drug hits, have now sold off Treasury Bonds, Gold, Euro and Japanese Yen quite hard, all in favour of US Dollar gains. Some assets have corrected more than others, with an example of Silver being down almost 17% since the start of the month. But let us remember General Benrnake's words, which states that more stimulus is not of the table, but just postponed for now. What would bring it back on the discussion table?

Under-performance of economic data and downside surprises to economists forecasts, would be the correct answer, and according to the Citigroup Economic Surprise Indices ranging from Developed Markets to Emerging Markets, we seem to have a rollover occurring just as the market is the most bullish on the US Dollar. If good economic data takes stimulus talk off the table and sells off currencies in favour of the US Dollar, than from a contrarian point of view, bad economic data prior to elections in November might prompt Money Printer Ben to do another injection of drugs to all the junkies.

Dollar Is Technically Overbought

I do not fancy myself as a short term trader and this blog does not focus on such technical swing trading analysis very often, having said that, recent US Dollar rally has pushed into overbought levels against many foreign currencies from the short term perspective, including Swiss Franc and Japanese Yen, together with Precious Metals like Gold and Silver.

Furthermore, following the US Dollar Index, also known as DXY, is not the best way to gage Dollars strength and its future moves. How strong is the Dollar really? As we can see in the chart below, not as strong as you might think. While the DXY Index is still above 80, Trade Weighted Dollar is struggling. As a matter of fact, the chart shows how Dollar, through the Trade Weighted Broad Index, has been weaker and weaker against majority of the global currencies. On the other hand DXY "looks" like a stronger version only because it is heavily weighted towards the Euro.

Greenback rally started across the board in early May 2011 as the QE2 sell off ended and after 11 months of rallying, TW Dollar it is still only as high as its November 2010 and October 2009 low. How is that for a bullish move when it comes to the King Dollar? Not very bullish if you ask me. You'd expect a lot more gains over an 11 month period. The thing is, majority now hold Dollars and are expecting further gains towards new highs (chart below), while in late 2009, late 2010 or even in middle of 2011 we had insane level of Dollar shorts.

Last weeks COT reports showed a build up in short contracts against the Euro, Pound, Yen and Swiss Franc, while the market reduced long positions in the commodity currencies. Tomorrow's report will most likely show even more shorts added against the Euro, Pound, Franc and the Yen, and further cutting of long positions in the commodity currency complex. In my opinion, it is not a good time to be bullish on the US Dollar, when majority of Dumb Money are also on the same side of the boat.