Since discussing the possibility of the dollar strengthening over the past few days, it’s important to recognize the effects it will have. One effect is that global equity market returns will look worse when looking at them in U.S. dollar terms. When looking at the table, which has almost all equity markets across the world with positive returns, it’s important to remember that’s being helped by the weak dollar. When you buy foreign stocks, you need to adjust for currency exposure if you don’t want the trade to be a proxy bet against the dollar. That’s worth nothing because this year making a bet against the dollar has been fine, but lately the dollar has been increasing.

The dollar rallying and the Russell 2000 (RUT) rallying are part of the same trade which is the bet that American economic performance has started to improve relative to the global economy. Of course, the RUT trade has been a big upswing of 9.72% while the dollar has only rallied 1.96%. This might mean the dollar will catch up slightly; it probably won’t fully catch up since it’s less volatile than the small cap index. The dollar might be helped by the unwind of the Fed’s balance sheet which is starting in a couple weeks. Draghi’s decision on the tapering of the ECB’s QE also impacts the dollar. That decision will finally be coming in October after Draghi has waffled on it for much of the year. As you can see from the chart below, the futures contracts are pushing back the expectations for the first rate hike in this cycle. I think there’s a possibility that Draghi is trying to act dovishly on rates to make up for the incoming hawkish move which is the tapering. It’s extreme dovishness to discuss policy moves in 2019 which is longer than a year into the future.

I don’t think this push towards being dovish on rates implies the ECB will do a larger than expected taper in October, but it might imply the bond purchase program will end in late 2018 or early 2019. Saying rates will be negative when the purchase program ends could stabilize the markets in late 2018. This makes sense when you consider how relatively little guidance that far out effects current market pricing. The QE program in Europe was bigger than the Fed’s and was more aggressive because it purchased corporate bonds instead of government bonds. Draghi knows he will have a tough time weaning the market off of QE. However, it’s counterintuitive to see Draghi discussing 2019 interest rates while still not making a final decision on the QE program in the first half of 2018.

If the QE is extended longer than June 2018 or the tapering is less than 20 billion euros, I think the dollar will rally. If the QE is extended for shorter than 6 months or is more than 20 billion euros per month, the dollar will strengthen. QE policy and economic conditions are the only rational reason for the dollar to sell off versus the euro when the Fed is raising rates and shrinking the balance sheet while the odds of a hike in 2018 by the ECB fall sharply. While the European economy has been doing well, the American economy catching up once the hurricane data as passed, could fuel a dollar rally.

Small & Micro Caps On A Tear

While the dollar has only showed a glimmer of hope to the bulls betting on the buy America trade, the Russell 2000 has had an extreme move. I usually don’t delve into technical analysis unless the factors shown are historically powerful. As you can see from the chart below, the RUT is flashing a signal that it is the most overbought on the 14 day relative strength index since 2003. That’s a powerful sign because the latest rally is about half the size of the post election rally. It’s important to recognize that this technical indicator doesn’t imply there will be a long term trend change. Instead it means there might be some weakness next weak because of how quick the increase has come. Microcap stocks have been on a similarly impressive run as the IWC micro cap ETF has been up 25 of the past 27 days. A breather may be in order shortly.

Energy Beats Tech For Once

Besides the small caps and the banks, another sector which I haven’t mentioned that has been on a tear lately is energy. As you can see from the chart below, in the first three weeks of September, the S&P 500 energy index was up over 8% while the technology sector was down about 2%. The tech sector was brought down by AAPL during that period. Since the 25th AAPL is up 1.81%. Although oil was down on Thursday, it has been doing well in September, increasing from a $47 handle to a $51 handle. The WTI crude pricing is at about a $6 difference from Brent because of the hurricane effects. The difference should fall down to $4 when the effects are mitigated. Oil has been rallying because of geopolitical conflict in the middle east as the Kurdish election in Iraq which aimed to give the Kurds independence caused Turkey to threaten to stop allowing the Iraqi oil to flow through its pipelines. The other possible reason for the rally in crude is that the OPEC had the highest compliance for its cuts ever in August. These cuts along with strong global economic growth have pushed up prices.

Conclusion

I think the short dollar trade is ending, but my opinion will change depending on what Draghi does in October. The Russell 2000 and microcaps will probably consolidate their gains next week. Oil prices and energy stocks have been rallying because of threats to shut down the Turkish pipes that carry 85% of Iraqi oil.