As you’re well aware, Dear Diary, I’m a proponent of the secular US Dollar (USD) bull. I’ve highlighted 82 as the USD Index’s (DXY) long-term prime meridian, and that’s the doorstep upon which we stand today. Regardless, USD’s 2012 performance is surprisingly tepid, all things considered. I want to delve into two matters herein: EURUSD’s surprising strength and DXY’s Quantitative Easing burden. I’m also going to parlay this into a discussion about the DXY/SPX divergence that’s opened up this year.
Jim Bianco recently discussed the phenomenal rut in which USD finds itself this year:
Back in January, foreign exchange strategists predicted 2012 would be the year of the dollar. The US currency was expected to enjoy strong gains as a positive recovery story unfolded in America. Instead, the dollar is stuck in a rut [+0.3% ytd]… inexplicably for many traders given the divergence between the health of the US and eurozone economies, the dollar is also barely changed against the euro this year [EURUSD -2.1% ytd]…
For currency traders, the big question is whether the US Federal Reserve will embark on another round of “quantitative easing”–dubbed QE3–this year.
Mr. Bianco’s posit propelled me to review the realities of today’s FX markets, starting with EURUSD’s defiant strength. This week, UBS echoed a lot of what I’ve said regarding the strong Euro. They distill their argument down to 4 points that have contributed to EURUSD buoyancy:
- Global Currency Wars- Developed nations’ QE vs. EU’s lack thereof.
- Current Account Surplus- Eurozone (barely) operating in the black.
- Sovereign Wealth Funds- High energy/oil prices giving Middle East sovereign wealth funds excess petrodollars to diversify in Europe.
- Repatriation- European corporations selling foreign assets for liquidity.
I can live without that third point about sovereign wealth funds, but otherwise I wholeheartedly agree with UBS’ assessment. There has been no creation of net new assets (i.e. non-steralized monetization) in the Eurozone to this point: not via the EFSF, ELA, LTRO, SMP, EIB, nor the Troika. That’s supportive of the Euro. While the ECB’s real policy rate is negative like its sister central banks’ across the developed world, the nominal rate is befuddlingly high–particularly on the “all-in” Taylor Rule basis in which QE has taken the Fed/BOJ/BOE beyond ZIRP. Further, unlike other developed nations, assets’ yields across the Eurozone are significantly positive on a real & nominal basis, although this does reflect the distress of the EMU periphery.
Finally, Mr. Bianco has to put EURUSD into context. While the annualized performance can’t have appeased the shorts, the pair has had a choppy descent from a 1.60 top in 2008 to its 1.25 handle today, including a relentless slide from 1.50 starting May 2011. A record high commercial EUR short interest was reported this week, which coincides neatly with my technical read:
- $EURUSD has to find support @ 1.25 inverted H&S, otherwise it’s spellbound by longer-term bear channel since 7/2008 top w ~1.05 sppt. $FXE May 22, 2012
This alignment suggests we’ll see a short-covering rally in EURUSD off its 1.25 right shoulder of an inverted Head & Shoulders:
UBS’ first point returns me to the passage by Mr. Bianco, in which he essentially says ‘FX markets await a determination as to whether or not the Fed will embark upon QE3.’ He’s largely correct in this observation. Despite bearish catalysts for its major pairs, USD has come-up lame against the likes of GBP, JPY & AUD–not just EUR. Particularly since Operation Twists ends June 30, conventional wisdom expects a material upside move in DXY. However, I look back to expirations of QE1 (3/31/10) & QE2 (6/30/11), and the latter also doesn’t exhibit a big, preemptive upside reaction. Since the first sequel, the threat of a QE-successor has noticably lingered like a wet towel on top of DXY. Today, the market expects $700B in QE3 injections according to swap-spread differentials. By the transitive property, that must also imply a market expectation for de minimis Eurozone intervention. In other words, FX markets suggest Eurozone solutions will again call upon sterilized liquidity provisions a la LTRO.
I’ll take that one step further, though: while FX markets were indecisive as to QE3, equity markets fully subscribed to the Bernanke Put. A correlation analysis of DXY:SPX shows an uncharacteristic positive relationship given our bear market, and that correlation is currently as strong as it gets historically speaking:
This pair will continue to recouple, a terrific compression trade for the macro crowd. A Beta-neutral pair trade (short SPX/long DXY) initiated after a short-covering EURUSD bounce off the 1.25 right shoulder should only implode in the event of an unexpected, definitive QE announcement. Since the market has taken to fading regional Fed Presidents’ monetary quips–whether dovish or hawkish–only Ben Bernanke (or maybe Tim Geithner) has the clout to move markets with rumor. To wit, I reiterate my expectation that Mr. Bernanke will defer action until after Eurocrisis Event Horizon; why waste resources before a crash? Also, I know he will await a 25-30 bp drop in Inflation Breakevens,¹ which would signal proximate deflation.
¹Inflation Breakeven = Treasury yield – TIPS yield; 10-year breakeven ~1.75% & 5-year ~1.50 have historically prompted intervention from this Fed.