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The Only Dollar Move That Matters Now

By Cumberland Advisors (Michael Lewitt)Market OverviewDec 24, 2015 01:18AM ET
www.investing.com/analysis/the-only-dollar-move-that-matters-now-377300
The Only Dollar Move That Matters Now
By Cumberland Advisors (Michael Lewitt)   |  Dec 24, 2015 01:18AM ET
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I want to zero in on the one asset class that affects every other one. I'm talking about the U.S. dollar.

Now you might think the dollar's going to crash. That makes sense. The value of all paper currencies continues to be destroyed by central banks who are trying to reduce their mountains of debt. In the U.S., the Federal Reserve has piled on more than $4 trillion in quantitative easing since 2008.

But unlike other paper currencies, the dollar is in a unique position and is much more likely to get stronger.

In fact, the dollar's been getting stronger and stronger since 2014.

And if the dollar moves up through its next resistance level, it would rock financial markets.

Let me show you how to get this right. Because everything depends on what happens to the dollar.

The U.S. Dollar Affects Every Other Asset

The U.S. dollar is the oxygen of the global economy. Everyone takes it for granted, but it determines the value of every financial instrument in the world - stocks, bonds, commodities, real estate, art, collectibles, you name it.

So let's talk about the dollar's direction (up)... the forces pushing it... the consequences for investors... and what key support level to watch on the dollar index.

When the value of the dollar changes significantly against other currencies, it causes the value of these assets to change as well. And that is exactly what started to happen in June 2014. The value of the dollar is driven by monetary policy, which is set by central banks around the world. Central banks set policies that affect their interest rates and the value of their currencies.

For example, if the Federal Reserve lowers interest rates directly (by lowering the Federal Funds rate) or indirectly (through QE), it lowers the value of the dollar because investors holding dollars will earn a lower interest rate on their dollars. In contrast, if the Federal Reserve raises interest rates (directly or indirectly), it raises the value of the dollar. The same applies to other central banks - if they take actions to raise or lower the interest rate paid on their currencies, the value of those currencies respond accordingly.

Sometimes different central banks act together to lower interest rates and sometimes they don't. Right now we are in a period in which the Federal Reserve and other major central banks in Europe, Japan, and China are not coordinating their actions, which has enormous consequences for the dollar. And in turn, what happens to the value of the dollar has enormous consequences for other financial assets.

Let's take a look at how that's been playing out - and what's next.

The Dollar's Been in "Rally Mode" Since 2014

The US Dollar Index (DXY) is an index that measures the value of the dollar relative to a basket of foreign currencies. The composition of the index is euro (57.8%), yen (13.6%), British pound (11.9%), Canadian dollar (9.1%), Swedish krona (4.2%), and Swiss franc (3.6%). As you can see, 70% of the index is tied to just two currencies - the Euro and the Yen.

The Dollar Index (DXY) broke out of a long-term trading range and started moving up sharply in mid-2014 until it broke a long-term trend line at 95 in December 2014. It has spent most of the subsequent period trading above this key level, signaling that it could trade much higher in the coming months.

DXY:CUR Chart
DXY:CUR Chart

Source: Bloomberg


The reason for this sharp rally in the dollar index was that the Federal Reserve was widely expected to end its QE program in October 2014. Investors began anticipating this a few months before that happened. At the same time, investors began expecting the European Central Bank and the Bank of Japan, which are responsible for setting interest rates on the euro and the yen, respectively, to move in the opposite direction. The European and Japanese economies were struggling and needed stimulus.

And sure enough, on October 31, 2014, the Bank of Japan along with Japan's largest pension fund announced a massive QE program that included not only massive purchases of Japanese Government Bonds (the equivalent of our Treasuries) but also stocks and ETFs. This was another step in what is known as Abenomics, an economic stimulus program adopted by the government of Prime Minister Shinzu Abe to try to end Japan's decades-long period of deflation and slow growth. Abenomics had already moved the value of the yen from 85 to over about 107 and this announcement moved it much lower to the 120 range (remember, if more Yen are needed to equal a dollar, the yen is weaker, not stronger).

This was followed in January 2015 by the ECB's first QE program. The euro, which had already started to weaken - from the $1.40 range in early 2014 to $1.21 on December 31, 2014 - plunged on this news to as low as $1.05 during the first quarter of 2015. It has since settled at either side of $1.10 (with some technical spikes higher).

So what next?

All eyes are now on the Fed. A hike in the Federal Funds rate from 0% to 0.25% is long overdue and would likely push the dollar higher against the euro and the yen as well as other currencies in the DXY. Recent market turbulence has sowed doubts regarding whether the Fed has the courage to raise rates by even such a small amount. But even if the Fed doesn't move, the ECB and Bank of Japan are committed to further weakening their currencies. That means further dollar strength can be expected.

And if the Fed doesn't move in the near-term, it is still almost certain to move before the end of the year (most likely in December) barring a total market meltdown (Super Crash) before then.

What a Strong Dollar Means for You

The consequences of a strong dollar are important for investors. Here's what you need to know.

First, oil and other commodities are traded in dollars. A strong dollar will make it difficult for oil prices to rally and could push them down further from current levels. I will be discussing commodities in future Sure Money emails to you, but for the moment readers should not be counting on any imminent recovery in commodity prices in large part because the dollar is likely to remain strong. You cannot be betting on a strong dollar and higher oil at the same time - those positions are inconsistent with each other. The same is true for a strong dollar and other commodity prices including copper, aluminum, and other metals.

Second, a strong dollar is deflationary; it makes it difficult for U.S. companies that sell products abroad to increase prices since their goods are made more expensive by the strong dollar. This means that corporate profits will remain under pressure, which in turn will pressure stock prices. Earnings growth at S&P 500 companies has dropped to zero after years of strong growth, meaning that companies are going to have to resort to cost cutting or financial engineering like stock buybacks to push up their stock prices. Overall, a strong dollar should be a headwind for stock prices and we are already starting to see the effects of this. If you are invested in companies like Caterpillar Inc. (NYSE:N:CAT) and Qualcomm Incorporated (O:QCOM) that have significant foreign sales, you should reduce your exposure now.

Third, emerging markets are already suffering at the hands of a strong dollar and will continue to suffer. Emerging market countries and companies borrowed enormous amounts of money denominated in dollars. Now those debts are worth more and are going to be harder to repay. Readers can buy the ProShares Short MSCI Emerging Markets (N:EUM) to profit from continued weakness in emerging markets. This ETF rises when emerging markets stocks weaken.

Fourth, readers don't have to sit around and do nothing. You can profit from the dollar rally by investing in dollars and selling short euros and yen. The most direct way you can do this is through three ETFs.

  1. You can buy PowerShares DB US Dollar Bullish (N:UUP), which closely tracks the exposures in the DXY. This ETF rises when the dollar rises.
  2. You can buy the Euro by buying ProShares Short Euro (N:EUFX). This ETF rises when the euro falls.
  3. And you can sell short the Guggenheim CurrencyShares Japanese Yen (N:FXY). Your short position will rise in value as the Yen weakens.

Here's What to Watch in the Dollar's Next Move

Keep an eye on the DXY. You can track it here

The euro is still trading at over $1.10 and the yen is still trading at 118. These two currencies, which comprise 70% of the DXY, are likely to weaken significantly further. The euro is likely to move much closer to $1.00 and the yen to 145, and further moves lower than those are also in the cards.

This is the key...

Those levels would move the DXY through its next resistance level of 98 and unleash another bout of dollar strength that will rock financial markets.

The Only Dollar Move That Matters Now
 

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The Only Dollar Move That Matters Now

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