While stock pickers have celebrated the demise of the “risk on / risk off” trade, some aspects of this dynamic are still alive and well.
For example, there is a massive unappreciated “risk on” component of a weak $US dollar, and a corresponding “risk off” profile for a stronger buck.
Meanwhile, oil prices busting through $100 / bbl are pointed at as proof positive of the inflation fires around the world. Yet there seems to be more inflation in record $USD short positions than core U.S. prices.
As the Financial Times reports:
Positioning data from the Chicago Mercantile Exchange, widely seen as a proxy for hedge fund activity, revealed that the value of bets against the dollar rose $11.5bn in the week to March 1 to $39bn, $3bn more than the previous record of $36bn in 2007.
Traders said the dollar was suffering given expectations that the Federal Reserve was likely to maintain its ultra-loose monetary policy in coming months as other big central banks raised interest rates…
Oops! Wrong focus, guys. You’re just in time to get squeezed — more on that in a minute.
As the Mercenary team has repeatedly noted (see here and again here), the dollar index is up against a significant long term trend line. As of this writing, our aggressive long $USD trade (via UUP, time-stamped in the Live Feed) looks well timed.
While weakness in the $USD index technically means “USD is getting weaker” (duh), the practical outcome of this weakness is “EURUSD is getting stronger.” That is because the EURUSD comprises 57% of the weight of the US Dollar Index.
It is nearly impossible to conceive of the dollar index getting weaker without the EUR appreciating against the $USD — and vice versa for strength.
The euro had been strengthening, at least until this week. Does that imply the Eurozone sovereign debt crisis (and bank solvency crisis) is over? Certainly not. How could the crisis be considered over, when sovereign credit spreads are right up against their highs?
For example Portugal — one of the at-risk peripheral countries in Europe — is just a few basis points from record borrowing costs. Ireland also faces near-record borrowing costs. These are clear signs the market views the eurozone debt crisis as alive and well.
Consider the credit spread issue in light of rate hike talk from the European Central Bank (ECB). The ECB wants to raise rates to head off energy inflation. But since oil is priced in USD, any weakness in the USD would probably result in higher oil prices to compensate. A weaker USD is widely interpreted to help support high ($90/barrel) and perhaps even higher ($100+) oil prices.
And so, a rate hike in Europe might actually support still higher oil prices in $USD terms, probably fully offsetting the impact of the move. Talk about shooting yourself in the foot…
Then, consider the remarkably inelastic demand of oil. Very little impacts the demand for oil, so how do slightly higher European interest rates factor in? Not very strongly as far as demand is concerned. The major impact of a rate hike by the ECB might be a stronger Euro, but not lower Energy costs.
Unfortunately for Europe, there is another big catch. A too-strong EURUSD would probably throw the eurozone into a recession. Growth isn’t that great across the eurozone, and where there is growth, it is mainly due to exports. Much of the remarkable German growth story from last year was due to exports. A strong EURUSD chokes off this avenue of economic growth.
So the proposed rate hike all but insures Europe would be stuck with both high or higher energy costs and reduced exports — at a time when the peripheral countries are struggling mightily under record borrowing costs! This is a recipe for recession in Europe. (Are you listening Trichet?)
And this helps explain why you have to view a weaker dollar as a “risk on” proposition. To allow the $USD to get weaker, one must assume Europe can handle the EURUSD getting stronger — which is only so in a favourable (improving economic climate).
A too-strong euro plus high and rising oil costs spells recession in the eurozone. A recession is the one thing that the eurozone sovereign debt crisis cannot handle. So any weakness of the U.S. Dollar implies a massive “risk on” trade – because it assumes that eurozone growth will be strong enough to overcome such powerful headwinds.
The certain costs of a rate hike – a stronger EURUSD and slower economic growth — far outweigh the benefits of possibly (though not likely) lower oil price.
This is why I am a bit confused about the behaviour of the ECB. They seemingly want to destroy the eurozone economies (in order to save them from inflation).
So when looking at the multi-year support in the dollar Index, it seems like the blowing through this support (as aggressive dollar bears anticipate) would create a situation that immediately triggers the blowup of the Eurozone debt crisis. In fact, just threatening support here has re-ignited these fears.
This reality, along with the powerful multi-month chart support, offers clear reason to expect a floor under the $USD. A dollar index breach of support — i.e. an even lower greenback — is a “risk on” expectation that doesn’t match eurozone credit spreads near their highs with the Middle East in turmoil.
The ECB seems entirely clueless that it is pouring gasoline on the fire… and the market has seemed only slightly aware (at least until the past trading session or two) of the potential for the high oil/high euro combo to spark eurozone debt contagion at this stage.
Given all this, going long $USD via UUP – as team Mercenary already has — seems a solid play, especially against the record shorts in the USD index who are likely shaking in their boots right about now. Dollar bears are not appreciating the implied “risk on” component of their actions -– and the potential $USD short-covering rally could be tremendous as a result.