Getting Ready for "The Turn" in the Dollar
By Frank Barbera CMT. October 21, 2008
Over the years, I have written a number of controversial articles, some which were correct, and some which were off base. Like a player that bats .300 in baseball, in the financial markets, if you can correctly see what’s coming next more then half the time, you are doing reasonably well. I start today’s article on this note because I know that right here, right now, this article and this call are bound to be among the most highly controversial and represent one of the more aggressive calls I have made in some time. Yet, looking at the state of the currency markets, it appears as though a truly major turn is dead ahead. Now, I am writing this article from the point of view of a market technician, and I want to state up front that I have no idea “why” the Dollar will weaken, and why the Euro will bounce back. For whatever reason, I would assert that at the moment, an “inflection point” of epic proportions is now directly ahead. Of course, there is always room to speculate where fundamentals are concerned. In markets as super charged as the currency markets are at the moment, an important trend change could come from something as simple as some European finance minister opening his mouth and talking about lower rates. Alternatively, maybe some economic data could trigger a major swing. From the standpoint of the message of the charts, the fundamentals matter little. The charts are shouting out potential “trend change” and that is all we are paying attention to at the current time.
In looking at the currency markets and the Dollar markets, the current trends seem to have gone too far in one direction without any significant counter trend move. In the case of the US Dollar, it is clear that the Dollar has benefited from the unwinding of carry trades that had been implemented over the years by the hedge fund community. Looking back at the last decade, the growth of assets under hedge fund management has soared into the trillions with a substantial portion of that money leveraged in various carry trades. Chief among these was the YEN Carry trade where hedge funds borrowed sold Dollars to borrow cheap money in Japan, and then used that money to purchase assets on a leveraged basis, often in the natural resource space. Now, with hedge funds in a period of forced redemptions, a gigantic margin call of sorts have been sent out around the world, forcing these funds to unwind their leveraged trades and buy dollars to pay back their carry trade loans. As a result, the advance in the US Dollar has been driven by largely mechanical trading, and forced reversals of previously favored long positions.
It is perhaps the ultimate irony that these events have transpired at the very time that the US Government is creating billions and billions of new dollars out of thin air. In the past, other countries have walked down this road and none has ever succeeded in sustaining such an attempted reflation for long without incurring huge pain in the currency value. Yet, the US has embarked down this well trodden path in what could be ultimately seen as the road to ruin. Only time will be the ultimate arbiter of the wisdom of recent decisions. Thus, we know that with a mass of evidence to the contrary, a cloud of suspicion should be hanging over the current advance in the greenback. From here, what we need to see to validate these suspicions is some solid statistical evidence. In my view, I have found what I believe is strong evidence – statistical evidence, that the Dollar advance should be near its end.
In the chart below, I show the US Dollar Index and its one year trading band (255 trading days) going back to the late 1960’s. Most of the time, prices are contained inside the bands. On rare occasions, prices will move either up to, or in even rare occasions, outside the upper band. On these occasions when prices push outside the upper band, there are only two signals that are being given. Either the market is in ‘kick off’ mode and is signaling a major intent to move seriously higher on a sustained basis, or the movement outside the upper band is a marker for an over-extended market that is about to reverse. In such cases, the reversal is usually compelling and usually comes within just a few days.
In the lower chart, I have tried to capture the current situation for you in graphic form. In the bottom clip I plot the percentage distance above the upper band. The formula is today’s close less the value of the upper band, divided by the upper band and multiplied by 100. The two horizontal lines are drawn in at zero (lower line), where prices equal the upper band, and at +3% where prices are 3% outside the upper band. At today’s close, the Dollar Index ended 4.68% outside the upper band, the most over-extended reading on record. This tells us, that something very big is under way in the Currency markets. Either the Dollar is moving into a new bull market mode, or the Dollar is reaching an major over-extended peak.
Going back to January 1975, a period covering 8,559 trading days, we find that there have only been 40, that’s right, 40 trading sessions (.0046% of the time) where the Dollar Index was 3% or more above its one year upper trading band. Over that time, the verdict has been about even as to whether such a posture was a sign of a major top or a sign of a larger kick off. What is very telling is that in those instances where an important peak was being recorded, the market normally only stayed above the +3.00% boundary for a two to three days. For the Dollar Index, today was Day 2. Usually, in the bearish outcomes, within a few sessions, the market was then subjected to a violent reversal in the other direction which locked in place a major Dollar peak. In looking at the Dollar's chief counter-party, the Euro, we see what appear to be the classic ingredients for an important trend reversal. Using the daily chart, it is clear that maximum downside momentum for the Euro was seen back on September 11th, with the Euro at 139.73 and the 14 day RSI at +15.72 and the 9 day RSI at +10.59. RSI becomes the indicator that is normalized on a zero to +100 scale and allows for quick comparisons. In that vein, while the Euro ended today at 130.67, the 9 day RSI finished at +17.38, with the 14 day RSI at +23.01. So far, the RSI gauges are holding well above their former lows, even though prices are considerably below those former lows.
This is the kind of classic technical set up, known as a positive divergence that suggests that the advance in the US Dollar is losing upside momentum. It also underscores the extreme nature of the current market as today’s figures are deeply oversold. In the case of the 9 day RSI for the Euro, we have seen a daily close below +18 on only 74 occasions going back over the last 23 years to the beginning of 1985. That’s a total of 5,763 trading days, implying that with today’s close below +18, the Euro is in the top 98.72% of oversold extremes. On the 14 day RSI, there have been only 249 readings below +24, which leaves today’s value with an oversold ranking more deeply overdone then 95.70% of all data readings in the last 23 years. As a result, I believe that regression to the mean will soon be the phrase in play in the currency markets. For the badly depressed Euro which is now down nearly 20% from its July peak, a base should develop over the next two to three days followed by a sharp recovery rally back up -- in my view, toward the 140 to 142 area initially. Over the next two to three months, I would not be the least bit surprised to see this market snap back 50% of the entire decline which would come in the zone between 147 and 148. In addition to some of the shorter range gauges, other longer term measures are also highlighting what is a deeply oversold and over-extended market condition.
Above: FXE, an exchange traded fund that tracks the Euro exchange rate.
Above: Medium Term RSI for the Euro in the zone of the most oversold values seen in years. Can this be sustained, or is this the end of the downtrend? We believe a bottom is at hand.
Above: Commodity Channel Index for the Euro – Medium Term - also among the more depressed values ever seen and showing a positive divergence. This suggests a market close to a major turn.
In addition to the Euro, no article on the currencies could be penned without talking about the huge collapse seen in the Canadian Dollar and other resource currencies like the Aussie Dollar and Kiwi Dollar. At the current time, the Canadian Dollar is now right down to its one year lower band and is in the zone of what should be very major longer range support.
A glance at the chart above shows that longer range Overbought-Oversold gauges are down to historically compressed values for the Canuck Buck. Coming in to a very short term view, we see that on the hourly chart, prices appear to be close to completing a double bottom, again, with pronounced positive divergences on RSI. This is the set up for a major turn and recovery in badly depressed asset values.
Finally, in the case of the Aussie Battler, the decline in recent months has wiped out fully two thirds of the prior bull market advance. This decline has generated secular oversold values, the kind which are seen perhaps no more than once a decade. For those with an eye for value, it seems that now would be a good time to start following foreign assets denominated in the currencies of these natural resource producers. In the case of both Canada and Australia, the currencies are virtually ‘de facto’ backed by the huge resource based economies, something which I believe will be an enormous asset in the years just ahead.
Above: Australian Dollar with Medium Term Overbought-Oversold Gauge.
Another country that is also substantially depressed is Mexico and its Peso, again, opening up some interesting opportunities for those seeking high yield investments. While we know that the outlook for currency markets is at the present, ultra controversial, in my view, there is a good case to be made that the Dollar is very close to a major reversal top, something that would benefit a wide variety of natural resource assets which at present, all appear to be very badly depressed.
Above: the Mexican Peso collapses from $10-$11 to the Dollar to now close to $13/$14 to the Dollar, a huge decline in a short period of time.
At the close, the stock market ended lower with the DJIA falling 239.30 index points to end at 9026.17, while the S&P 500 finished lower by –30.35 index points to close at 955.05. On the NASDAQ prices tumbled by 74.61 index points to end at 1695.42 for a loss of 4.22%. For the S&P, Tuesday produced a decline of 3.05%, while for the DJIA, the loss was 2.58%. The 10 Year Bond fell .19 basis points to 3.70% while the price for Dec. Gold fell by $16.00 to end at $774.00.
That’s all for now,
© 2008 Frank Barbera