Fundamentals are still smiling at the dollar

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“I don't think..." then you shouldn't talk, said the Hatter.”

― Lewis Carroll, Alice in Wonderland

Commentary & Analysis

Fundamentals are still smiling at the dollar

092418 dollar smile.jpeg

There is a simple framework we can use to help evaluate the likely intermediate-term trend of the US dollar, measured in months and quarters.  It is referred to as the dollar smile. I first saw this concept in a research note written by Stephen Jen, when he was with Morgan Stanley many years ago.   I do my best to keep it in mind as I trade Mr. Greenback, as at times it helps keep me out of the weeds. At the moment the dollar smile is indeed happy with the buck.

 Three scenarios gleaned from the dollar smile:

092418 dollar smile.png

 1)        Left side of the smile reflects an appreciating dollar as global risk comes back into the financial system.  From our current perspective, we are thinking about a major “risk off” safe haven bid into the dollar resulting from a big drop in the stock market.  Though such a risk bid can be short-lived, it can be a powerful initial driver sustained by relative fundamental factors over the intermediate term.

2)         The middle of the smile reflects dollar depreciation against the major currencies as the US economy decelerates or muddles through soft spots, while relative economic growth and yield (central bank policy catchup) begin to improve among in both the developed and developing world economies; i.e. some global inflation.    

3)         The right side of the smile reflects an appreciation in the dollar on the back of strong US growth and rising yield differentials.  This backdrop pulls in hot money and a greater share of foreign direct investments as the US economy grows faster than key country competitors and the Fed is expected to hike rates faster than other major central banks (CBs).  This process naturally tends to be self-reinforcing. 

Below is a chart showing the path of 2-year relative yield spread favoring the US dollar compared to the euro, pound, Australian dollar, and Canadian dollar.  Yield spread keeps grinding in favor of the dollar.

092418 yield spreads.png

Looking at this another way, in the chart below we have compared the US dollar Index to the 2-year yield spread for the United States – Eurozone (the euro represents about 57% weight of the US dollar index).  A rising spread (red line) means the US yield is increasing relative to the Eurozone.  And as you can see, this spread has blasted off in favor of the United starting back in October 2016.  Yet, the US dollar index is now nine points lower.  With Eurozone growth concerns back in play, it doesn’t seem we will see this yield gap narrow anytime soon.  And if interest rates still matter, and we think they do, this spread reality seems dollar supportive to say the least.

092418 dollar vs spread weekly.png

There is legitimate background expectation of CB interest rate policy catchup with the US Fed.  Granted, the Bank of Canada and Bank of England have signaled rates will be headed higher soon.  Additionally, the recent Reserve Bank of Australia minutes from their last meeting suggest the bank will be hiking sooner than was expected.  Two points here: 1) We do not expect any major CB to be as aggressive as the Fed over the next 12-18 months, and 2) if there is a major risk event, i.e. a major stock market correction and/or a markdown in global growth as a result of the ongoing US-China trade tensions, the relative impact will likely moderate expectations more quickly for BOC, BOE, and RBA than the Fed.

Keep in mind currencies at the core are considered free-floating instruments in the developed world, and most of the key emerging markets.  Free-floating means the price driver for a currency is based on supply and demand.  In a world where global capital flows freely across borders (China’s effectively closed capital account being the major exception) these fund flows into currencies can further be broken into two broad baskets: 1) hot money; and 2) *foreign direct investment (FDI). 

*Foreign Direct Investment definition should also consider US corporate repatriation triggered in large part by the recent tax cuts in the United States. 

So, if you consider these two baskets of flows, you can then better understand why higher relative interest rate yield and economic growth for a country are powerful determinants for its local currency.  Hot money moves to the highest real yield, and FDI heads to the country with the best longer-term capital gains opportunity which is an economic growth decision. 

Presently, the US dollar is the winner on both yield and growth; and that lead may acceleration, at least on a relative basis.   

Fundamentals influence currency values and currency values in turn influence fundamentals in a continuous feedback loop; this is what often drives powerful self-reinforcing trends.  

092418 dollar index weekly.png


And we suspect the next powerful trend in the dollar is up—and we are targeting to 100 once what we suspect is a minor correction is over.

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  Jack Crooks, President,

Black Swan Capital

jcrooks@blackswantrading.com

www.blackswantrading.com

772-349-6883

Comment

USD/CAD Daily: Bank of Canada in play and trade deal looming?

We, including our subscribers (we take the same trades we suggest) are short USD/CAD from 1.3145. Rationales at the time of entry: 1) Bank of Canada in play based on the recent Deputy Governor’s hawkish speech, and 2) a trade deal with the US…and of course the Wave setup below that has played out nicely so far. But as we all know, one Tweet from President Trump can change all that. :)

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USD/JPY 240-min: Elliott Wave Nesting?

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For the record we are short USD/JPY from 111.33 and have been taking some heat. But our setup seems to make sense and the pattern was tested yesterday. A series of 1-2s or what is referred to as Elliott Wave nesting (we make up things to fit our story I realize that; but we like it anyway). This view is negated above 111.75 to decent risk/reward we think.

091218 jpy 240.png

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Major FX Pairs Update

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Major Pairs Update
4 September 2018/9:19 p.m. ET
 
Quick Summary:
$-Index – Lower in minor [c] of B toward 93.00
USD/JPY – Lower in minor (c) of [c] toward 107.97
EUR/USD – Looking for a five-wave rally toward 1.1963.
GBP/USD – Minor correction complete; looking for a rally toward 1.3162-89.
USD/CAD – A trade deal would likely trigger another wave down toward 1.2700.
AUD/USD – Still grinding lower; target now toward 0.7130; watching for key day reversal.

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Kiwi Concerns…

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“For things to reveal themselves to us, we need to be ready to abandon our views about them.”

– Thích Nhat Hanh

 Commentary & Analysis

Kiwi Concerns…

Kiwi_sign.jpg

 ·         Premise: If key correlations, albeit loose, but not likely spurious, remain intact, and we finally get a nasty correction lower in global stocks, the New Zealand dollar could get clobbered.

The chart below compares NZD/USD to the 2-year yield spread between New Zealand and the US, which has collapsed from over 5% back in 2009 to -0.94% today; plus, the green line overlay represents the Hong Kong Stock Exchange—a good proxy for emerging market equities to which NZD maintains a correlation. 

082818 nzd spread hsi.png

Ø  I suspect the yield spread favoring the US will continue to widen given the relative economic positioning between the two countries; NZ’s close ties to a slowing China is a concern.

Ø  Sooner or later, we will finally get a real correction in stocks.  I suspect such a correction will be accompanied by a risk-bid into the US dollar, creating more pressure on emerging markets; that in turn will likely be reflected in a big sell-off in Hong Kong equities. 

Thus, the New Zealand dollar appears particularly vulnerable once this minor correction higher is complete. 

We want to get short Kiwi once this US dollar correction is over. 

082818 dxy.png

If we get another leg up in the dollar, as I suspect, the New Zealand dollar could easily its post credit crunch low made in early 2009, at around 48 cents.  Stay tuned.

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Jack Crooks, President,

Black Swan Capital

jcrooks@blackswantrading.com

www.blackswantrading.com

772-349-6883

Comment

Dollar Index Daily View...

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With dollar speculative bullish positions are a bit frothy, it fits with our expectation for a correction lower; i.e. work off some dollar bulls before another rally phase.

082818 cot.png

US Dollar Index:  Looking for at least a test of 93.71, but would expect a push beyond there into 93.00 on what I have labeled an expanding flat pattern. Is dollar weakness still predicated on the stock market acting okay?  Most likely.  

082818 dxy.png

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