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Still Bullish on the U.S. Dollar Index

(October 8, 2009)

Dear Subscribers and Readers,

Despite the 2.6% gain in the Dow Industrials and the 2.9% gain in the S&P 500 since Monday morning, the major market indices still remain within their September 16th to 30th trading ranges.  While yesterday's pause (on light volume) signals that sellers are not rushing back into the market – despite the major two-day rally on Monday and Tuesday – I continue to believe the market will at least be mired in a trading range for the next couple of months.  Specifically, I believe many retail and specialty retail stocks have risen too far, too fast.  I also believe the 2009 post-Thanksgiving and Christmas shopping season would disappoint (retailers are for the most part expecting 2009 Christmas shopping sales to be flat versus last year's).  Since retail and other consumer discretionary companies make up a significant portion of the S&P 500 – and since they have typically led the broader market – I continue to advocate a “cautious” stance for the global equity market for the rest of this year.

Let us now discuss the gist of our commentary.  We started signaling our bullish stance (mostly on a three to four-month timeframe) on the US Dollar Index in our September 24th commentary (“A Trend Reversal for Commodities?”).  Quoting our September 24th commentary:

With the US and global economic leading indicators rallying to new highs, there is virtually no doubt that the Federal Reserve will end its credit easing policy once they have finished purchasing their current commitment ($300 billion in Treasury purchases, $1.25 trillion in agency MBS, and $200 billion in agency debt, for a total of $1.75 trillion high-quality securities).  Since this has been one of the most worrying Fed policies among inflation-wary investors, an ending of this “credit easing” policy should provide some support to the US Dollar, especially since the European Central Bank has made no commitment to ending its de-facto easing policy anytime soon (its latest policy has just effectively guaranteed the entire Irish government debt by allowing Irish banks to post Irish government bonds as collateral at the ECB).  I now expect a sustained rally in the US Dollar Index for the rest of this year, with a corresponding weakness in commodities, commodity-related currencies, and of course, the Euro.

As mentioned in our commentaries over the last week, we retain our bullish stance on both the US Dollar Index and commodities, despite the surprised 25 basis point hike by the Reserve Bank of Australia yesterday.  Moreover, with US households still deleveraging and become more productive by starting new businesses and building up human capital (many of the smartest graduates in the 2009 graduating class have gone on to graduate schools and the sciences, in lieu of Wall Street), the chances of a sustained and structural decline in the US Dollar Index and in the competitiveness of the US economy are no longer as high.  As discussed in our September 27th commentary, we believe the US economy will continue to deleverage for the next several years through a combination of a restriction in credit creation, a rise in disposable income, and an increase in certain loan (most likely focused in commercial real estate) defaults.  This long-term deleveraging trend is also evident in the following chart showing the monthly annualized growth in consumer credit (12-month smoothed) from January 1989 to August 2009:

Monthly Annualized Consumer Credit Growth (12-Month Smoothed)* (January 1989 to August 2009) - Both revolving and non-revolving consumer credit growth has been generally on a declining trend since the middle of 2001, although revolving consumer credit growth (such as credit debt debt) turned up slightly in late 2006. However, starting in mid 2008, the growth of the 12-month average of total consumer credit started trending down, and just shot into negative territory in the latest month of August 2009!

As shown in the above chart – while liquidity has remain ample – credit creation by US households has continued to decline after making a short-team peak in the middle of 2008 (note that it has been on a long-term downtrend since the middle of 2001).  In fact, the year-over-year growth in consumer credit growth (12-month smoothed) has just sunk into negative territory (at -0.34%) – representing its lowest level since December 1992!  From its peak in July 2008 till August 2009, total consumer credit outstanding has declined by a whopping $120 billion to just $2.46 trillion.  The ongoing decline in consumer credit has two bullish implications for the US Dollar Index: 1) A signal that US households will continue to pay down their debts, or in effect, covering their synthetic short positions on the US Dollar, and 2) It will directly shrink the US current account deficit, as a lack of consumer credit growth typically results in a decline in consumer goods imports from China, Europe, etc.

In addition – and as we mentioned before – a sustained rise in the US Dollar Index at this point also won't be surprising given the (still) oversold conditions in the US Dollar Index, as exemplified by the following chart showing the level of the US Dollar Index vs. its percentage deviation from its 200-day moving average:

USD Index vs. Percentage Deviation from its 200 DMA (January 1990 to Present) - The percentage deviation of the USD Index from its 200 DMA hit a level of negative 7.52% on September 22, 2009, the most oversold level since late March 2008 (the week after the end of the Bear Stearns crisis). At the same time, the USD Index hit a low of 76.09, its most oversold level since early August 2008. Given the gradual ending of the Federal Reserve's *credit easing* policy in the coming months - as well as the weakening of commodity prices and the ongoing easing policies by the European Central Bank - we now expect the USD Index to strengthen in the coming weeks. As of Wednesday evening, the USD Index is still at a very low 76.40.

As mentioned in the above chart, the percentage deviation of the US Dollar Index from its 200-day moving average hit a -7.52% reading on September 22nd – representing its most oversold level since late March 2008 (when the Fed was forced to “back stop” the entire broker-dealer community after the Bear Stearns crisis).  At the time, the US Dollar Index closed at 76.09.  Since then, the US Dollar index has remained near its lows, and closed at a level of 76.40 yesterday.  In addition, even though the ascension of the G-20 (especially China, India, and Brazil) will lessen the role of the US Dollar as the world's reserve currency, we do not believe this will have much impact on the US Dollar Index.  Sure, the Chinese Renminbi should continue to rise against the US Dollar in the long-run, but subscribers should note that the US Dollar Index (as defined by the futures contract traded on the New York Board of Trade) is a measure against the value of only six other currencies, namely the Euro, the Yen, the Pound Sterling, the Canadian Dollar, the Swedish Krona, and the Swiss Franc.  In other words, the rise of the Chinese Renminbi and the Indian Rupee would have no effects of the US Dollar Index going forward.

Finally – precious metals – the “antithesis” of the world's reserve currency, the US Dollar, is now significantly overbought from a sentiment standpoint.  The following chart, courtesy of, shows both total assets managed and cumulative flows into the Rydex Precious Metals fund over the last three years – and thus directly indicates retail investor's sentiment towards precious metals (the following caption discusses why this is the case):

Rydex Precious Metals (RYPMX)

As indicated in the above chart, the popularity of the Rydex Precious Metals fund has spiked substantially over the last week.  This signals extreme retail investors' bullishness in precious metals, and logically, bearishness in the US Dollar.  With the Reserve Bank of Australia now in “hiking mode,” I would not be surprised if the Federal Reserve becomes more hawkish in the next meeting should gold continues to rise (and should the US Dollar continue to decline).  We thus remain bullish on the US Dollar Index for the rest of this year.

Signing off,

Henry To, CFA


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