Dollar Bulls At Record Highs

Topics Covered

• Assets are not responding to money printing
• Break even rates signal a risk off environment
• US Dollar net long positioning at record levels

Overview

The selling pressure remains in risk assets, despite modest recoveries in certain asset classes. While US equities staged a powerful reversal on Monday, Crude Oil is still moving lower. Gold is also giving up its gains. Treasuries are sitting near all time record high prices, while the US Dollar is flirting with its resistance at 82. The bottom line still remains the same: investors are selling risk due to possibility of a disorderly default in Eurozone, triggered by Greece as the first domino. Nothing has been done, announced or hinted by authorities yet and risk off trades are very crowded. Short squeeze could occur.

Economic Data

Nothing new to report.

Equity Markets

Away from the the shorter term buying opportunity currently present in the equity markets, due to oversold levels and high bearish sentiment, I want to point investors to a warning flag in the whole risk asset space. The chart below shows that major global equity indices have currently failed to march higher, despite large amounts of liquidity, money printing, rate cuts and stimulus promises around the world. Many investors seem to be dumbfounded as to why I've turned bearish "all of a sudden", while I'm dumbfounded as to why many investors, some of which I respect a lot for their skills, "still remain bullish".

They say bull markets climb a wall of worry, while bear markets slide a slope of hope. There is always a amazingly strong argument as to why one should stay bearish at the bottom and contrary to that also stay bullish at the top. Today, this argument comes in the form of investors belief based on their recent conditioning. Since March 2009, majority have now become trained to listen and trust into central bank activities, so hardly anyone is getting "too bearish" anymore. This is perfectly illustrated by the Investor Intelligence Survey chart below. While there is a certain amount of pessimism within equities, as they have sold off by, majority are not really bearish or panicking to mark a true bottom. It seems that investors are clam or even better put... complacent. They hope the central banks will save the day.

Whatever the problem and whatever the risk, we know central banks stand ready to act, right? They told us that. As an aside note, I have actually created an email folder, where I place emails from every investor I talk that has mentioned something similar to the following quote: "central banks will not let things get out of control". Believe me, it is currently the most popular folder in my inbox. In my opinion, central banks can only postpone the crisis, not prevent it. And they have been doing their job posting it with QE2, Operation Twist and LTROs. I am pretty sure they will try to post pone it again with QE3 and/or another LTRO. We will find out soon enough, but more importantly - will it work? The quote in the chart below is from a great market technician by the name of Tom McClellan. It was said in early 2011, as Russell 2000 was storming ahead to new highs. If we were to apply the same wisdom to today's price action, we can see that something is not right within the market environment. If there is plenty of liquidity (apparently), with central bank program after program, so why aren't small caps responding?

I've stayed bullish for as long as possible in this cyclical bull, but now cracks within the market are starting to appear left, right and centre. In a bull market, one is meant to stay bullish until there is a sign of an end in both the business cycle and the market cycle. Jesse Livermore was quoted saying that a 100 years ago and it is still true today. During last years market crash and European turmoil, I called the bottom in equities on October 04th and insisted that a recession will not occur. I remember one very popular blogger put forward an outlook that 2011 was going to be the worst bear market ever in financial history - now he thinks equities, as well as all other risk assets, will rise into 2013/14 and no recession will occur.

For me, the wall of worry has disappeared. Equity revenues have completely recovered, earnings are now at record highs and gross profit margins are at never before seen sky high levels. Personally, all I see is hope. Hope of central bank intervention, hope that Greece doesn't default, hope that China stimulates and hope of further rise in equity earnings. No investor should be blamed in this uncertain and volatile time. It is hard out there. My outlook here is bearish on almost all risk assets and I could be just as easily wrong as I am right. But, in my opinion, the market is talking to us. Wrong or right, those who can understand its code, can prepare for the worst, but still hope for the best.

Please remember that this is a secular de-leveraging cycle and capitalism / free market in the West is trying to write off bad debts, starting with Greece. Politicians and central bankers are not letting the free market operate and with excess liquidity measures (money printing programs) they are only kicking the can down the road. However, eventually the free market will force its way in, but the longer we postpone it, the worse it will be. A default of some type is coming sooner, rather than later. What I am trying to say is that despite QEs and LTROs, risk assets seem not to be responding anymore, as majority are failing to make new highs. Be very careful!

Bond Markets

The chart above shows US Treasury Break Even rates over a ten year maturity, which is a measure of expected inflation within the system by market participants. It is also a great measure of risk on and risk off trends. As we can see right now, inflation expectations are falling, which means deflation trade is dominating. Equities, commodities and foreign currencies have all taken a beating since March of this year. So far, every single deflation trade / risk off trend has been paused by central bank action. Fundamentals are bad as debt levels continue to grow from 2007 levels, but the can is being kicked further and further down the road. As inflation expectations fall, Ben is most likely getting an itchy trigger finger. Is QE3 on its way and more importantly will it work beyond the short to medium term sugar rush?

Currency Markets

According to the COT report on Friday, cumulative net long USD positions have now reached record bullish levels. With almost 28 billion dollars betting on the greenback, this is the highest bullish position since at least 1999. Hedge funds are shorting the Euro at record positioning, while also remaining net short the Yen and the Franc. Bullish positioning can be seen in the Loonie as well as in the Pound, while commodity currencies like Aussie and Kiwi have seen major reductions of net longs.

Recent Merrill Lynch currency survey I received, which came out on 14th of May, showed that EUR/USD positioning is now at historical extremes. This is what the newsletter went onto say:

"The net long in USD vs net short in EUR has reached a survey high. Last month’s move was driven by a significant increase in USD longs, this month’s change resulted from a considerable increase in EUR shorts. April’s increased optimism could be rationalised by fading QE3 expectations, this time round, the Greek election results have been the dominant driver. While the net percentage of investors expecting Greek debt restructurings has declined from 55% to 50%, 15% of investors now expect two or more countries to restructure from 9% a month ago."

Finally, last weeks currency article also showed that Public Opinion is very very high on the Dollar. I still hold a core position in Silver and do not own any US Dollars at present. From a contrarian point of view, I believe all risk assets have a chance to create a major short covering rally, if a catalyst is given (money printing, another bailout, more Chinese rate cuts, etc etc). If the short squeeze occurs, I will evaluate further.

Commodity Markets

Nothing new to report.

Credit Markets

Nothing new to report.

Recommandations

• I bought some S&P 500 Calls on Monday as the rally started. That could have been capitulation from the short term breadth, sentiment and technical indicators. Therefore, after a re-test of lows a recovery rally could start. However, I believe main trend is down, so eventually I want to short equities.
• I bought Silver Calls mid last week, so I will not be doing anything in the PMs market for now. My further action depends on Western central bank further actions. Weak action will make me reduce my core holdings and close out Calls.
• Finally, I am looking long and hard at all Agricultural commodities. I believe the bull market will resume soon. My watch list has been Wheat Calls & Softs ETF, but I am considering just buying the overall sector through RJA once again. I still have not done anything yet and I might not until selling pressure globally eases.