How Much Further Will The Dollar Rally?

An Air of Inevitability

One thing recent years have shown is certainly that currency markets have a tendency to overshoot and trend very consistently in the same direction. Sentiment and positioning analysis has in some cases failed to work with unwavering regularity. In fact, it didn’t even help much if fundamentals were not necessarily in line with the trend – the yen being a prime example. Sentiment and positioning on the yen were at extremes for a long time, and while the BoJ has enacted an unprecedented “QE” operation, Japan’s actual money supply growth has remained fairly tame. Not only that, according to John Hussman, the yen is now the most undervalued major currency on a purchasing power parity basis as well (note though that we are a bit wary of such data – how one can reasonably calculate PPP is hard to fathom given the vast array of prices in the economy).

 

Annualized growth of M1 (currency and demand deposits) in Japan. At a recent level of 4.8% it remains well below US and euro area money supply growth rates (7.6% and 6.8% respectively)

 

Of course, in the yen’s case an argument can be made that the markets are punishing it for a perceived loss of quality, as the massive bond buying by the BoJ means the government owes ever more of its debt to itself – an absurdity that cannot remain without consequences forever. Recently Japan’s government announced it would fund more building of bridges to nowhere, i.e., a huge stimulus package is to be enacted, which means that efforts to bring the debtberg under control remain postponed until further notice.

This brings us to the dollar’s strong upward trend that has taken shape last year. Similar to the yen’s downtrend, it has an air of inevitability. The Fed is seen as tightening monetary policy, while others are loosening theirs, or are experiencing an increase in risk aversion (this is the problem of a number of major commodity producing countries). Moreover, it cannot be denied that the dollar’s trend looks technically strong.

 

Extreme Enthusiasm

Even though this hasn’t worked recently, we continue to follow the positioning and sentiment situation in the dollar, and its main counterpart in the dollar index, the euro.

Below is a long term chart of the net hedger position in DXY futures, with the small speculator position overlaid (the net hedger position is the obverse of the combined net speculative position). Small speculators have never been more excited about the dollar – rallies of similar size have never produced anywhere near comparable positioning (the chart shows the entire history of the contract). Just for the sake of completeness: the big speculator position is close to a record as well, at 49,000 contracts net long, and the disaggregated CoT report reveals that asset managers currently hold a gross short position of precisely zero – i.e., they are not even short a single contract. Surely this is a hard to beat extreme.

 

 

Hedgers have never held a larger net short position in DXY futures, and small speculators have put every previous record in their net long position into the shade – click to enlarge.

 

Not surprisingly, a similar picture emerges in sentiment surveys. Sentimentrader has constructed a special indicator, the Optix, which measures the average public sentiment expressed in the most popular and well-known surveys combined. At 89% bulls, it is at a new record high. Interestingly, this is an indicator that has actually worked quite well – until late last year, that is.

 

 

Public sentiment – all important sentiment surveys combined. As the red circles indicate, the Optix has actually worked well as a short to medium term contrary indicator – click to enlarge.

 

We can definitely state that by now everybody “knows” that the dollar can only go higher. There has never been less doubt about this prospect. Experience tells us though that very often what everybody knows isn’t really worth knowing. It seems therefore more and more likely that there will be at least a short term change of trend. What might trigger it? There are a number of possibilities, ranging from the next ECB announcement to the Greek election to upcoming US macro data. It actually doesn’t matter, as the news can always be fitted to the trend.

It should be noted that positioning and sentiment are not only at or near extremes in the dollar index as such, but also in all the currencies currently declining against the dollar – including the euro. Below we show the net positioning of hedgers for the entire history of the euro (speculators are cumulatively net short by the same amount).

 

 

It seems everybody also knows that the euro can only go lower from here – click to enlarge.

 

Again, it must be stressed that at least in recent weeks and months, positioning and sentiment data have not worked very well as contrary indicators, which is actually a sign that the underlying trend is very strong. So maybe we’ll have to wait for a 100% bullish consensus on DXY before it corrects, although that seems actually not very likely to us.

There is one hint in the markets – subtle though it is – that the dollar may be nearing a short to medium term peak. Again, it has to be taken with a pinch of salt, because it could simply be a case of a delayed reaction. However, for now it is what it is – a divergence. We are referring to the fact that gold has refused to make new lows in dollar terms in recent weeks, in spite of the rally in the dollar becoming even more relentless.

A similar gold-dollar divergence was evident at the 2001-2002 twin peaks in the US dollar index – of course one major difference was that the Fed was easing at the time, but so were other central banks. From a purely technical perspective, gold continues to look weak, while the dollar’s uptrend looks perfectly intact (if overbought). The divergence is mainly noteworthy because it is lasting for two months already. It must also be kept in mind that the trend of the dollar is only one of the factors driving gold – however, between July and November 2014, there has been a very pronounced negative correlation, so something has clearly changed.

 

DXY and gold – a two month long non-confirmation – click to enlarge.

 

Conclusion:

Maybe a bullish consensus of 89% and record speculative long positions will do the trick and cause a downtick or two in the dollar? Admittedly the fundamental rationalization forwarded in favor of additional dollar strength (diverging central bank policies) seems extremely obvious, especially given what has happened with the yen since the Abe/Kuroda tag-team arrived on the scene. Perhaps it is a bit too obvious though.

 

Addendum: Another Divergence – the Ruble and Crude Oil

We recently opined that after the rebound from the ruble panic in mid December, we would expect the currency to embark on a “retest”, possibly, even likely, putting in a higher low. The latter is not certain yet (the retest may yet fail), but renewed weakening is definitely underway. What is interesting about it is that the ruble is still a good way above its panic lows, even though crude oil prices have just kept on collapsing in a heap. In this case we would think that the divergence increases the probability that the “retest” will be successful.

Incidentally, among major economies, Russia is still the least indebted one overall. Its government and private sector debt combined amount to about 45% of GDP, way below the developed nation average of approx. 280% and only about a quarter of the emerging market average of 155%. Japan’s combined private and government debt to GDP ratio is at 415% – Japan is nearly ten times more indebted than Russia relative to economic output. All the above mentioned ratios exclude debt of financial intermediaries (as this would lead to some double counting).

 

A noticeable divergence between the ruble and crude oil prices has formed – click to enlarge.