U.S. Dollar Is Dangerously Close to “Pulling an Icarus”
The U.S. dollar is flying on wax wings. And its rapid ascent during the last five months may have brought it a bit too close to the sun.
The greenback might not crash into the sea, but it could lose some altitude from current levels.
Notwithstanding the dollar’s rally this year, its bear market trajectory remains the dominant trend. Here’s some context…
From the middle of 2011 through the end of 2016, the U.S. Dollar Index enjoyed a nice long uptrend that boosted its value by a hefty 42%, according to the International Commodity Exchange (ICE). But this bullish trend ended early last year.
Just about the time President Trump was buying a new lunchbox and sharpening his pencils for his first day in the Oval, the Dollar Index starting drifting lower. Over the ensuing 12 months, the Dollar Index fell 15%, according to ICE.
Although the Trump administration approved of the dollar’s weakening trend, it did little to cause it. Typically, investment flows wield the greatest influence over foreign exchange trends. And in the case of the dollar, investment flows during 2017 favored overseas markets.
As dollars flowed from here to there, many foreign markets logged big gains. From the beginning of 2017 through the first month of this year, for example, the MSCI Emerging Markets Index soared more than 50%, while the S&P 500 advanced only about half as much.
But these stock market trends reversed in January, which was also when the dollar’s downtrend reversed. Since then, emerging markets have been much weaker than the U.S. stock market.
Simply put, trends like these are both the chicken and the egg. Foreign stocks are weakening, so investors sell and move capital back to the U.S., which causes foreign stocks to weaken even more and invites even more selling of foreign stocks.
But eventually, the vicious cycle comes to a halt… at least for the short term. And it looks like we may be very close to one such turning point.
Investor sentiment readings provide the clue. Specifically, the “dumb money” is very bullish on the dollar and, therefore, bearish on foreign currencies like the euro.
“Dumb money” is a somewhat vague category that contains a variety of investors. But their unifying trait is that they tend to find themselves on the wrong side of a market when it is close to a turning point. They tend to be big buyers of something just as it’s about to fall… or big sellers just as it’s about to take off.
Traditionally, one part of the so-called dumb money consists of small speculators, also called “noncommercial” investors. Another cohort consists of professional fund managers.
To clarify, fund managers are generally quite bright, but as a group they tend to “herd” around the same trades at the same time. Consequently, this group tends to “look dumb” at market turning points. Not always – but often.
The chart below illustrates this phenomenon. It tracks the net futures positions of professional investment managers alongside the trend of the Dollar Index. As you can see, these investors tend to lean hard in one direction, just as a particular market is about to head in the opposite direction…
At the start of this year, for example, this group built up a big bet against the dollar, right before it lurched higher. And the group did the exact same thing in September 2015 and March 2016, immediately before major dollar rallies, according to the Commodity Futures Trading Commission (CFTC).
On the flip side, professional money managers amassed big long positions – i.e., positive bets – in the dollar around November 2015, 2016 and 2017. On each of these occasions, the dollar tanked shortly thereafter, according to CFTC.
Now, once again, this group of investors is building up a big long position in the dollar. If past is prologue, the Dollar Index is likely to begin a meaningful decline sometime soon.
Meanwhile, another indicator is sending the identical signal. Capital flows into “dollar bullish” ETFs are high and rising, according to Bloomberg. Inflows like these often occur near short-term peaks in the dollar’s value.
The opposite is also true: Capital flows out of dollar funds tend to jump near short-term lows in the dollar’s value…
Inflows spiked last September, shortly before the Dollar Index sold off. Then in January of this year, outflows hit a significant high, just before the dollar rallied sharply.
At the moment, we find ourselves on the other side of that trend. Capital flows into the PowerShares DB U.S. Dollar Bullish Fund just hit their highest level of the last two years, according to Bloomberg.
This data point does not guarantee a dollar sell-off, but it does suggest one is likely.
Longer term, the dollar may be facing a new headwind: tariffs.
“Past periods of protectionism in U.S. history have actually been associated with subsequent dollar weakness, not dollar strength,” said Zach Pandl, co-head of global FX strategy at Goldman Sachs. “We think that something similar can play out now.”
Deutsche Bank analyst Torsten Slok agrees. “If you impose tariffs,” he asserts, “especially at an extreme degree and have retaliation and an effective uncertainty tax, then it should be weakening the dollar. Foreigners probably look at the dollar and feel they don’t really understand where this trade policy is all going and what is the end game, and lose confidence.”
Confidence is pretty much the only factor that determines currency values.
Governments and government policies that inspire confidence tend to safeguard the strength of a currency; governments and policies that don’t, well, don’t.
Certainly, the dollar remains the planet’s premier currency. And its status remains unassailable.
But that doesn’t mean it can’t suffer a serious setback if the new protectionist wave becomes a tsunami.
Watch this space.