Rhody Trader

The question “Why has the value of the US dollar not declined sharply?” was asked recently, and not for the first time. It’s one that I think is on the mind of a lot of market observers these days. Here’s the answer I provided:

All the major currencies feature low interest rates (relatively speaking), have governments printing money for quantitative easing and/or fiscal stimulus, having increasing deficits and debt, and negative economic growth. Keep in mind that the dollar rises or falls in value against other currencies, currencies that are in the same boat. Actually, the US is widely seen being the first economy to recover. That helps, as does the fact that the dollar is still the biggest safe haven currency, so when folks are worried that’s where they put their money.

I think the problem a lot of folks have is that they tend to look at the dollar singularly, forgetting the fact that the forex market is one of relationships, the cross-valuation between currencies. When the whole boat is sinking it’s a question of who has the most bouyancy.

In response to my answer I got this follow-up question:

That explains a lot of it. However, what do you see in the long-term? Asia Pacific and other Asian economies might strengthen whereas the US economy has many issues to face for long-term sustainability. The US might lose their edge, at least relatively, in the long-run. Do you see the dollar weakening in the long-run?

If so, which currency do you see as having the most potential in the medium to long-term?

I have no specific view of the long-term future. There are just too many variables, and when it comes to the fundamentals I often find myself seeing contradictory elements. Will the dollar lose at least some of its standing as global reserve currency? Absolutely. It will take a while, though – probably considerably longer than some folks would like. I wrote on that subject on my blog a little while back if the post Enough of the Dollar BRICabrack. 

Naturally, as economies like China and Brazil continue to expand one would expect their currencies to improve against the dollar (if the countries in question allow that to happen), but that’s really only one part of a very complex equation.

What the questioner above was really trying to get at, however, is whether the US is going to turn into Zimbabwe with its hyperinflation. The reason why some folks see this as a potential development for the American economy is all the money the Federal Government, Treasury and Federal Reserve have been pumping into the economy.

First of all, the money the government and the Treasury spend or invest or whatever is funded by the sale of Treasury debt. So basically the money goes into the system, then comes back out again. It’s a sterilizing process which has little to no net impact on money supply.

Secondly, rapid increase in money supply requires both lenders and borrowers to create supply and demand for loans. Banks have tightened their lending standards and consumers are working on paying down debt, not adding to it. That means despite all the money the Fed has put into the system, we”re not seeing overall money supply growth. The chart below shows that well.

The grey line (M1) reflects what the Fed has directly been doing. The red/blue line (M3) is the line the line which most folks look at as the reflection of total money supply. Notice how sharply it’s been falling. That demonstrates very clearly that while the Fed has been pumping money in, it’s not turning into so-called bank money (money created by lending and borrowing). Until that starts to turn back up we won’t have any inflationary issues in the dollar.

Of course that leaves the question about how quickly the Fed will move to drain money from the system as the economy starts to improve.

The head-and-shoulders pattern on the S&P 500 daily chart has become a major talking point of late. By any way you’d care to define it, the neckline appears to be getting broken today. That being the case, I figured I take a look to see what the implications were. On the chart below I have drawn two lines – one the neckline (parallel from the low after the first shoulder), and the other the projection point taken by doing a measured move from the neckline by the same distance as the neck to top of the head measurement.

The projection point comes in a bit below 805, so we’re looking at a nearly a 10% drop from current levels. That’s meaningful.

In case there was any doubt about this being a negative development, make note of the lower Advance/Decline line. it’s made a new lower low after having done a lower high. You’ll recall my earlier post on the divergence that set up this roll over. The A/D line is confirming the price action, so we’re not getting any sign that we should be looking for a bottom any time soon. Of course the market could rally at any point. From here, though, I’m going to favor shorting into upside moves rather than trying to play the long side.

Kathy Lien posted on the subject of stock/forex correlations on Tuesday. She focused on the relationship between the S&P 500 and EUR/USD and USD/JPY, talking about how those linkages have changed over the course of the year. Some of the shifts have been relatively minor, but some have been significant. As I pointed out in my Traders Expo webinar, watching the changing links between markets can tell you a lot about what’s going on in the big picture. Correlations are also a subject I spent some time on in my book, The Essentials of Trading.

Here’s where I have to take Kathy to task a little bit, though, and potentially educate my readers a little bit too.

In her post Kathy said the following:

In comparison, since the beginning of the year, the correlation between these two instruments has been greater than 80 percent. This meant that 80 percent of the time that stocks rallied, the EUR/USD strengthened as well.

Tsk, tsk Kathy.

As any statistics student will tell you, correlation does not mean x% of the time this happens when that happens. In simple terms correlation means the amount of variance in the dependent variable (the forex pair in Kathy’s example) which can be explained by variance in the independent variable (stocks).

The reason this makes a difference is that the 80% thing could simply be reflecting the fact that the big moves in forex rates coincide with big moves in stock prices. In other words, stocks and forex could be going their own way on most days when the price changes are minor, but trade in close tandem on those dates when the markets are strongly directional one way or the others. This can be an important distiction, especially for a short-term trader.

A bond market analysis post by Chuck at Rebel Traders suggests that the interest rate market is at a pretty key juncture. Given that he seems to have a generally bullish near-term view on bond prices, I’m not sure why he titled the post Bond Market Blues, but whatever. Bonds, of course, were the subject of a recent strategy idea by a colleague of mine based on the If the US is Japan, Buy Long Bonds idea.

Chuck’s post is mainly technical in nature, but it’s worth tossing in a bit of non-technical information which relates. First of all, it’s quarter-end, which often involves capital moving around to fulfill reporting desires and/or requirements. Second of all, this is a very heavy data week, albeit a short one given the July 4th holiday at the end of it. This includes Thursday’s Non-Farm Payrolls report, which is often a source of market volatility. How bonds navigate this week could tell us alot about what the future may bring.

I may be a professional forex analyst, but I watching pretty much all the major markets. That includes stocks. One of the things I’ve watched closely is how the S&P 500 has done during the rally from the March lows. Most especially, I’ve paid close attention to the divergence that’s developed in recent weeks between the price action and what’s been happening with volume and the market internals.

The chart below shows the SPY with subcharts that include volume, short interest, and an advanced/decline line. Notice how while the market has risen in price, volume has been easing back and the A/D line has been falling away.

I like looking for these sorts of divergences to let me know when trends are likely starting to weaken. If the market is rallying, but volume is fading and fewer stocks are participating then there’s trouble abrewin’. In this case the rising short-interest is interesting, but it’s not near peak levels, so not a huge help.

Of course divergences can persist, sometimes for a long period, so they aren’t something you can trade in the immediate term. They are good, though, for helping you frame the larger picture and understand when the risks for a reversal are starting to outweight the potential rewards of continuation.

There was a recent post by Michael Kahn on his Behind the Headlines blog which he titled Trade the News? I Don’t Think So. The basic point of the piece is that what you read or hear in the media is more or less meaningless in terms of what the market is doing in the present. This is a subject that came up several times in the presentations I did that Traders Expo earlier this month. Michael is exactly right that inexperienced traders and investors expect current news, like the latest earnings headline for a stock, to drive prices.  The fact of the matter, though, is that the market is a discounting mechanism. It’s looking to the future and positioning itself for what’s to come.

Micheal attempts to drive home his point with this example of how things already known were driving the market. At least that’s what I think he was trying to do.

Why did the stock market peak in October 2007. The fundamentals looked great. Bears Stearns was still in business. Subprime had not exploded. There was not such thing as TARP and Bernie Madoff was just the guy who owned the market maker that kept screwing me on executions.

I think maybe based on a purely stock market view he might be right that things were looking fine from a fundamental perspective in the Fall of 2007. If, however, you were looking at what was happening in the money, credit and currency markets you would have known all was not well. They were all roiling in the Summer, well before the stock market peaked.

In fact, I can remember the bond market guys wondering aloud what the heck the stock traders were doing continuing to buy stocks when it was so clear to them that something wicked this way was coming. And not all stock traders were oblivious either. If you look at a chart of the financials you’ll see they were already turned down well before the general market did.

Of course the questions these days are whether financials will be the sector to lead the market out. Some folks think that must be the case. I’m not in that camp. I think while they definitely did get oversold, they are also extremely diluted due to all the new capital and the earnings environment is going to be more challenging. That to me doesn’t add up to strong EPS growth, which in the end is the requirement for a group to become a market leader.

The whole “The dollar shouldn’t be the only choice for global reserve currency” discussion is active again today thanks to the BRIC summit. This, of course, has been a running theme in the markets for some time now, with China and Russia being the two main instigators to start. The communique from today”s meeting made the following statement:

…there is a strong need for a stable, predictable and more diversified global monetary system…

This is basically a nothing statement. As Ducati and others have commented, there are all kinds of motivations for all this.

As has been stated repeatedly for months now, there’s basically no chance of any other currency. The reason the USD is at the top of the heap is because of the breadth and depth of the US financial markets and the relative social/political stability of the country. These aren’t things which can be easily or quickly replicated. Any move to create a second reserve currency would require building deeper regional financial markets, perhaps by merging them geographically. The Eurozone has moved in that direction with exchange mergers, but is still well behind the volume done by US institutions.

Even if something like IMF drawing rights, or some other multi-national institution, is used as the basis for a new currency there is still the question of why money would move  into them. Countries, companies, and institutions do trade in the USD and invest in USD-demononated assets. While an IMF “currency” could perhaps be developed for trade, there’s still not nearly enough of an underlying financial or asset structure in which investments could be made.

The USD is certainly bound to be progressively less influential over time. If, however, you see short-term reactions to “lets ditch the dollar” comments then you’re probably seeing a good fade opportunity, or just the market using it as an excuse to sell greenbacks.

I was flipping through a few charts, just looking to see what might be interesting, and came across a developing set up in gold which bears watching. As you can see from the weekly chart below, the Bollinger Bands for GLD have been narrowing rapidly.

 

Narrow Bands are often an indication of a market getting ready to make its next meaningful move. In this case that move may yet be a few weeks off, as the Bands do still have a ways yet to go before they get down to really narrow levels. The Band Width Indicator (BWI) line on the bottom of the chart (Upper Band – Lower Band divided by the Middle Band) shows that at a couple of points in the last few years they were tighter.

Now the market could still take off on a new trend from the current Band set-up, but the way GLD is backing off from the most recent peak (which was lower than the prior one) suggest that further general consolidation is the likely pattern, and thus a further narrowing in the Bands. In a few more weeks, though, GLD will be in a really nice position. Then we’ll have to see how the price action is developing to get a read on the likely direction it’s going to break.

I’m looking over the Obama budget stuff that was released in the last hour. Get this. The federal budget deficit projections for the next 6 years are

• 2009 $1.75 trillion
• 2010 $1.17 tln
• 2011 $912 bln
• 2012-2015 each under $600 bln

Add this all up and you get a cummulative budget deficit for the next six years of around $6 trillion. That means $6 trillion in new debt.

Ummmmm….Where’s the fiscal responsibility?

Getting the budget deficit down to $600 bln by 2012 sounds great in a speech - Yeah! We cut the deficit in half! - until you understand what it really means. The stimulus package will have worked it way out of the budget (at least mostly) by 2012, but we”re still going to have a deficit of $600 bln? Where’s all this cost savings Obama’s talking about? If he were really cutting out the fat, I should think he’s be able to get the deficit down further.

The bottom line is that baring a major upturn in the economy to massively improve tax receipts, it looks like Obama is just going to leave the country in much worse debt shape than it already is.

This, by the way, is a big part of why I like the short Treasury trade.

You may have heard that famous Elliot Wave guy Robert Prechter has taken off his short signal and advised folks to cover. If not, give this a read.

I found out today that my mentor – the guy I give a good deal of credit for my early market understanding development – told his readers that it’s time to buy. He’s basing that on “…key supports having been hit on long-term charts of the DJIA, S&P 500, QQQQ and the SOXX.”

He’s generally pretty good at picking the interesting points, so this will be worth watching.