The US dollar has relentlessly blasted higher in recent months, achieving its longest consecutive-week rally in history. Speculators have flooded into the world’s reserve currency for a variety of reasons, ranging from Federal Reserve rate-hike hopes to festering Eurozone worries. But the resulting massive dollar surge has left it super-overbought while breeding universal bullishness, the precursors to a sharp selloff.
But it’s critical to understand the strategic context. The mighty US dollar, despite Wall Street’s perpetual calls for a new bull, has been mired in a secular bear since July 2001 when the USDX crested at 120.9. As usual at major tops, bullishness was astounding. I was one of a very small handful of contrarian traders calling for a new dollar bear back in the summer of 2001 when most believed the dollar would rally indefinitely.
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The U.S. Dollar Index has recently been in one of the biggest blowoff moves we have seen in years. The lesson of the past blowoffs is that the downward slope out of the eventual top tends to symmetrically match the slope of the advance up into it.
This week’s chart shows us that the commercial traders of various currency futures contracts are already making a huge bet on a dollar decline. The indicator in the chart is one that I created several years ago by combining the commercial traders’ net position in multiple currency futures contracts into a single indicator. It does not include all of the currency related contracts which are now featured in the most recent Commitment of Traders (COT) reports, because they do not all have the same lengthy and consistent history of reporting. This indicator combines the commercials’ net position in the euro, yen, pound, Mexican peso, Swiss franc, Canadian dollar, and US Dollar Index futures, each weighted according to the dollar value of each position.
The current reading is the highest in the history of this indicator, which dates back to the creation of the euro currency in 1999. That is another way of saying that the “smart money” commercial traders are making a huge bet that this uptrend in the dollar is going to reverse itself. Commercial traders are often early in adopting a lopsided position, but they are nearly always proven to be correct.
This same lopsided position is also apparent when we look at the commercials’ positions in the individual contracts. Here is a chart showing the commercials’ net position in just the Dollar Index futures:
Dollar Index futures commercials net position
For this contract alone, the commercial traders are not quite at an all-time record net short position. But they are nevertheless at a pretty big one, and this condition usually is associated with an important top for the Dollar Index.
A similar (but opposite) condition exists in the COT Report data for the euro futures. A trader who is long the euro versus the dollar could also be said to be short the dollar versus the euro. The euro is the single biggest component in the Dollar Index, accounting for a larger weight than all of the other components put together. As the euro’s value has fallen in recent weeks, the commercial traders have responded by increasing their net long position to a huge degree, evidently betting on a big upside reversal for the euro (eventually). Upward movement for the euro would mean downward movement for the dollar.
COT data for euro currency
If the commercial traders are correct about the dollar reversing course and heading lower in value, then this will have profound implications across multiple market segments. Commodities prices should rise, commensurate with the percentage amount of the dollar’s fall. Small caps should reverse their recent trend of underperformance which is correlated to the dollar’s outperformance; when the dollar is up, small companies have a tougher time competing in the international markets.
And a falling dollar should also mean rising CPI inflation rates. All of these changes have been modeled by other indicators, as described in the previous articles linked below. It is nice when there are multiple layers of confirmation.
For stock market investors, this all matters because of how changes in the value of the dollar especially affect small cap stocks. Here is a chart comparing the US Dollar Index to a relative strength line for the Russell 1000 Index (large caps) versus the Russell 2000 (small caps).
Dollar Index and large vs small cap performance
The relative strength line in this chart rises when large caps are outperforming, or when small caps are underperforming. The 2014 blowoff up move in the Dollar Index has been hurting the Russell 2000 stocks and not having much of an effect on the large caps, thereby making the line rise. Once the dollar tops and turns down, small caps should be expected to be the outperformers again.
And oh, by the way, a big dollar downturn should be a huge tailwind for gold prices finally starting to rise.