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Neutral on the U.S. Dollar Index

(October 16, 2009)

Dear Subscribers and Readers,

For those who want to get a quick background on the US natural gas industry – including a history and the current issues facing the potential exploitation of our 100-year natural gas reserves – I highly recommend reading MIT Technology Review's article on the subject.

In our “ad hoc” commentary on the US Dollar yesterday, we stated our case on why we were reversing our bullish position on the US Dollar Index.  More specifically – despite the oversold condition in the US Dollar Index – there were still three major trends working against the US Dollar:

  1. The strength in the US stock market, which has been negatively correlated (and has increasingly been so) with the US Dollar Index since the late 2008.  While there is no reason why the US Dollar should remain negatively correlated with the direction of the S&P 500, other than for liquidity reasons and/or the positioning of global investors in general, we remain aware of the fact that many technical investors are trading with this relationship in mind.  As such, the US Dollar Index could remain in a downtrend as long as the US stock market's uptrend remains intact.

  2. The release of the latest FOMC minutes on Wednesday indicated that some FOMC members were entertaining a further expansion of the Fed's balance sheet (with only one FOMC member advocating a shrinkage).  In other words, the FOMC members remain generally dovish.  This is probably still scaring investors who are worried about the ongoing “debasement” of the US Dollar.

  3. The latest move by the Reserve Bank of Australia to start hiking rates has made market participants more wary of a renewed hiking cycle in commodity-linked countries, such as Canada and New Zealand – thus putting additional selling pressure on the US Dollar.

But as we mentioned, we should look at what the Fed does, as opposed to what they say.  One tool that the Federal Reserve has utilized to create more liquidity (i.e. print money) has been its mandate to purchase Treasury and Agency securities.  From April 1st to mid September (during the bulk of the US Dollar's decline), the Federal Reserve has consistently purchased $31 billion of securities on a weekly basis as part of its “credit easing” strategy.  Over the last three weeks, however, the Fed has slowed down its purchases dramatically – purchasing just a weekly average of $10 billion worth of securities over the last three weeks (ending October 14th):

Weekly Net Purchases of Treasuries and Agency Securities by the Fed (US$ billion) - After purchasing a substantial $46 billion in Treasuries and Agency securities for the week ending September 23rd, the Fed has dramatically slow down its *credit easing* program . Over the last three weeks, the Fed purchased only a total of $29 billion in Treasuries and Agency securities, and only $13 billion in the week ending October 14th. Going forward, this should be less bullish for global liquidity and commodities, but bullish for the US Dollar Index.

Again, look at what the Fed does, not what it says.  For now – with the Fed's asset purchases still relatively tame – things are starting to look up for the US Dollar Index once again.  Investors meanwhile are still more worried (rightly) about the Fed's rhetoric, as well as its ongoing commitment to and potential expansion of its credit easing strategy.  Until the unemployment rate starts declining or commodity prices start picking up, we do not anticipate the Fed to cut back on its credit easing strategy anytime soon (although its tentative expiration date is the end of 1Q 2010).  In other words, the Fed still has “one finger on the trigger” – which means that its asset purchases could quickly pick up again should the financial markets suffer a correction.

All of these trends suggest that US dollar bulls should remain wary.  With much of the world now betting against the dollar on both a short-term and long-term timeframe, why wouldn't you be?  But just like all “sure things” in life, they don't come without a price.  For example, the US Dollar Index is now at its most oversold level since late March 2008, as it is now trading 7.77% below its 200-day moving average (as shown in the below chart):

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 7.77% on Wednesday evening, 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 75.43, its most oversold level since early August 2008. Make no mistake: The US Dollar is now extremely oversold against other developed world's currencies,although a sustained upmove is nowhere close to assured at this point.

On an absolute basis, the US Dollar Index hit a low of 75.43 as its close yesterday.  Based on this measurement, the US Dollar Index closed at its most oversold level since early August 2008.  In addition, the bearish sentiment against the US Dollar Index is now very widespread (and getting extreme).  One analysis is even calling for the US Dollar to decline by one-third against the Japanese Yen (to 50 Japanese Yen) by next year!  That means a snapback could come at any time.

If you need to pin me down on a position, my most likely scenario would be for the US Dollar Index to consolidate for the rest of the year, with a slightly downward bias.  I expect the March to April 2008 lows (i.e. the 71 to 72 range) to hold on any further decline.  Should the US Dollar Index hit that level, we will turn bullish (although other developments may cause us to turn bullish as well).  Subscribers please stay tuned.

Signing off,

Henry To, CFA

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