iNVEZZ.com, Friday 25 October:
The German DAX has today traded above the psychological level of 9000 for the first time in its 25-year history. The blue-chip index reached an all-time high of 9010.5 mid-way through the day’s European session, after opening the day at 8980.63 and despite news of a slight hiccup in the German Ifo Business Climate survey this month. The climb through 9k hasn’t been sustained though, with slippage to 8994.5 as these words are typed.
While the German index logged this milestone, the EUR/USD extended to 1.3832, which is an almost two-year top for the pair. And meanwhile, the US Dollar Index slipped today to a new low at 79.07 or just 14 pips shy of its 2013 bottom.
To paraphrase Einstein, coincidence is the market’s way of remaining anonymous. It would be naïve for traders to suppose that currencies trade in a state of isolation, not influenced by developments in equities. In the remainder of this piece, we endeavour to identify the inter-market relationships which drive the value of the US Dollar Index and outline a possible road ahead for the greenback.
The USDX reached a three-year top of 84.96 on 9 July this year amidst speculation that the US Federal Reserve would start to curb its quantitative easing programme, the first step towards the normalisation of monetary policy and rate-tightening. However, the Fed’s dual mandates of achieving price stability and maximum employment saw postponement of the widely expected start of tapering in September while inflation remained stubbornly below target. The recent budget debacle and attendant government shutdown has amplified the pervading sense of economic uncertainty in the US and now most observers expect tapering to come some time in 2014 rather than during the balance of the current year.
Back in July Erik Swarts, an independent trader who pens the ‘Market Anthropology’ blog, theorised that the Dollar Index was then carving a major top inasmuch as traders had discounted the bleak conditions outside the states. The chart above, originally published just a day after the greenback’s top on 9 July, highlights how the relative performance of the S&P 500 and non-US stock indices have historically foreshadowed pivotal turns for the US dollar.
Writing in May 2009, Mohamed A. El-Erian from the fixed income fund PIMCO introduced the concept of ‘The New Normal’, which called for a major shift in global economic leadership from the US and the dollar to developing nations. In true contrarian fashion, Erik Swarts proposes that just as everyone has since turned their back on overseas markets, the greenback may be ready for a return to ‘normalcy’. He argues: “As conventional market wisdom has firmly embraced the notion that the US under the stewardship of the Fed is the safest neighbourhood to park ones capital, the original tenet of outperformance by developing nations - particularly China, is now overgrown with pessimism and stands of contrarian tinder.”
Since the July top, the USDX has been in the doldrums, while the rally in global equity markets has outstripped the sideways shows of the S&P500. Notably, the biggest outperformers have been the most abandoned markets, the Spanish IBEX and Emerging Market indices (the chart above is with a 9 July start date).
One might say: Great, thanks for the heads-up, but what’s next?
While the future cannot be known, the US equities markets seem to be pointing to the prospects of a significantly lower dollar value going forward. Swarts identifies a distinctive relationship between the relative performance of small and large cap stocks and the USDX (see chart below). In essence, over the past two decades both series have trended together, with typical lags between the greenback’s pivots and the large /small cap ratios (SPX:RUT).
Swarts concludes: “Should the RUT continue to outperform and inflate the next asset bubble, we would expect it to be at the expense of the US dollar - which as we have shown trends with large cap outperformance.”