Diary of a Financier

From the Trading Desk: Selling USD on Bad Risk/Reward

In Trading Desk on Wed 25 Jul 2012 at 11:08

I’m still long the US Dollar ETF (UUP), but I’ve been working on closing the position this week. I hate these kind of entries, because I have very weak conviction in this call. But, I wanted to meander through my reasoning for the move as best I can.

Last time I materially appraised the US Dollar Index (DXY) was in March, when I updated my surveillance of the 1995 Analogue. I concluded:

“I remain a bull on the secular USD trend, since the daily fractal is captive in a classic Cup & Handle pattern with a rim ~81.50. I expect a catapult above that resistance within a few weeks to a month.”

The catapult above that rim is complete. Also, the 1995 analogue still governs today’s pricetrend in DXY. (It’s actually progressed into the “1996 analogue” as time has passed.) The comparison remains uncanny for all fractals:

DXY 1996 v 2012 weekly- indicators & pricetrends are identical.

DXY 1996 v 2012 monthly

The analogue shows a -2.5% retracement beginning in May 1996, which aligns with today. Were today’s USD bull to mirror its secular rise¹ during the 1990s, I’d hang-on and fade such a short & sweet dip. But, the atmosphere continues to diverge from 1996’s, swinging the probability-weighted outcome toward bigger losses.

For example, the Fed has grown anxious over this summer. The second Jon Hilsenrath (Wall Street Journal) leak of the season came before the close yesterday. It was another planted attempt by the Fed’s mouthpiece to buoy a sinking market:

“Federal Reserve moving closer to action to spur growth… Bond buying, rate guidance, lower reserve rate among Fed options… Fed could make key decisions next week or in September.”

I don’t think we’ll get QE3 at next week’s meeting (July 31-August 1)—although I expect some real lipservice to that end. At the same time I’m not sure this market can wait until the FOMC September 12-13 meeting for relief. (More on this psychology coming in another entry.)

For the near-term, I have the 1996 analogue and an anxious Fed both recommending that I sell UUP. In addition, I have a lack of confidence in the short-term technicals. DXY’s daily fractal shows me no material technical developments to latch-onto, other than a bull channel. The problem with trending channels is you never know when they’re going to end. They’re an indefinite continuation pattern that can reverse without signaling. Since I’ve been tracking the SPX 2011 analogue for my equity exposures, I ran that same model using DXY. It suggests that USD will rally for almost two more weeks before correcting:

DXY v SPX daily- tracking the SPX 2011 analogue, expect DXY to have one last gasp higher before correcting.

Knowing that Ben Bernanke’s charging down the tracks like a locomotive, I can’t risk my gains in UUP to pick-up these last pennies.

~~~~

You would expect my abandonment of USD to have some affect on my opinion of other asset classes. In terms of inter-asset resonance, I want to avoid reading into this more than I should. That’s mostly because correlations within & between asset classes are still all bassackwards and therefore unreliable. For example, the DXY/SPX correlation² is 0.52 today, which is comparable to the atypically high-correlation era in the late 1990s.

In that vein, were we to see continued USD strength, I’m not sure it would necessarily work against SPX like most correlation traders would expect. Anecdotally, I can envision a large European intervention package trumping the Fed’s next card in currency wars. Something like that could provide a bid for USD & SPX. (I don’t want to get into my fair value model for EURUSD right now, but the minority breakup brigade has built a short position alongside quants who have modeled an expected value of EUR printing. A “shock & awe” stimulus could exceed all expectations.)

I once called that strong Dollar/strong equity performance from the late 1990s a “sign of organic growth.” At that time the Russian Crisis was spreading to southeast Asia and Latin America. I’ve read a few comparisons between the Russian Crisis and today’s Eurocrisis. The metaphor is flawless on all accounts… except for the most important: the Euro (EUR) currency is a rook compared to the pawn-ish Ruble (RUB).

SPX managed to blissfully skip through the crises of the late ’90s. Can it repeat that feat today? I have strong convictions about both equities and the Eurocrisis, but those are other conversations for other entries. Bottom line is, I’m dumping the last of my UUP before the weekend.

–Romeo

¹From May 1996, DXY rallied 38%, which equivalent would bring today’s index from 85.57 to >115.

²Correlation calculated from 50-period trailing, weekly data.

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