3 Things That Could Reverse the Dollar Rally

by: Kathy Lien August 19, 2008 | about stocks: ERE / ERO / EU / FXE / UDN / UUP    

Kathy Lien

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With the US dollar hitting a six month high against the Euro on a intraday basis, everyone in the financial markets are talking about how much further the dollar can rise. However not as many people have entertained the notion of what could trigger a major reversal in the US dollar. Since July, the greenback has risen 8 percent against the Euro and 7 percent against the British pound and in all likelihood, the dollar rally will continue. However a reversal in the US dollar could be triggered by factors that are more realistic than most traders may have expected and the longer the current rally continues, the greater the risk of a reversal. There are 3 things that I believe could trigger a brutal correction in the dollar including a turn in sentiment, a rise in oil prices and a big US bank failure.

The currency market is trending by nature and we have seen the strength of these trends over the past month, but it is important to realize that just as quickly as market sentiment has turned dollar positive, it can also turn dollar negative. All the currency markets needs is one big shocker and the EUR/USD could be headed back towards 1.50.

1. Sentiment Turns – USD long positions on IMM hit 14 month high

For the third week in a row, currency speculators have boosted their bets on a further rise in the U.S. dollar. Long positions according to the Commitment of Traders report has hit a 14th month high and whenever positions get this stretched, it is a red flag that calls for turn right around the corner. The logic is that with everyone who wants to be long is probably already long and as a result, there are only a few buyers left in the market.

2. Oil Prices Begin to Turn Higher

One of the primary reasons why the US dollar has rallied so dramatically is oil prices. Although it is oftentimes difficult to tell which is leading the other – the currency or the commodity, there is no doubt that the correlation is strong. Since its highs in July, oil prices have fallen 24 percent but with Hurricane season just beginning, anything close to Hurricane Rita in 2005 could send oil prices back higher. Still, I do not expect new highs in oil prices – they have peaked and any move would probably only take prices back up to $125 - $130 a barrel. We are already seeing this dynamic play out today as the rise in oil prices triggers a sharp rally in the EUR/USD.

3. A Big US Bank Failure

With the one year anniversary of the subprime crisis looming, the financial sector is back in focus – unfortunately for all of the wrong reasons. The markets are not celebrating the recovery in the financial markets but are instead focusing on fresh worries. Fannie Mae and Freddie Mac are in big trouble – their shares have plunged leading to talk about nationalization or a big bailout by the US government. Kenneth Rogoff, a former IMF Chief Economist is warning of a big bank failure ahead. Could it be Lehman Brothers who is rumored to be looking to sell their investment management business? No bank would sell such a high value asset if they were not desperate for cash. Also, SageCrest a US hedge fund who once had as much as $950 million under management also filed for bankruptcy protection today. Trouble is brewing in the financial sector and so far we have only seen a third of the writedowns that Nouriel Roubini aka “Mr. Doom” has previously predicted. Although bank failures have been far less in this cycle than in the past (8 so far), a big failure could lead to sharp sell-off of US investments and in turn, the US dollar.
Dollar Rally to Slow

I still believe that the US dollar is headed for more gains, but I expect the rally to slow. Other than producer prices, we do not have any major US data this week – only the Philly Fed index and leading indicators are on the calendar. Bernanke will be speaking about Financial Stability on Friday, but with no questions expected, the central bank head will probably stick to topic. As a result, this is prime time for a correction in the US dollar, but don’t expect this correction to last because the problems abroad in the Eurozone and the UK are only beginning. A move in the EUR/USD below 1.40 is still far more likely than a new high.

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This article has 9 comments:

  •  
    Aug 20 08:23 AM
    The dollar rally was triggered by timely intervention against an oversold condition. The market manipulators (I think they call them "Market Makers") have access to enough trading position information, in fact they have access to ALL of it now that it is computer-based, that it should be an easy feat for them to determine the size and timing of an intervention to induce a short squeeze. Such was the case for the bank short squeeze and they didn't even need money to do that one, just a rule change, and well, maybe a little cash to get it started.

    So in fiat land, the USD "rallies" against the Euro, and what are the explanations for this "rally"? Euro weakness. In other words, our fiat doesn't suck as bad as their fiat. Some cause for celebration!

    I am searching the known Universe for a genuine dollar bull who will begin a dialog with me by answering these questions and who will be willing to entertain my responses to their answers. Still no luck. How can the dollar recover from:

    1. US Foreign debt; please do not limit your explanation to the "% of GDP" factor so often cited elsewhere as I consider it to be somewhat less relevant in an environment of declining real GDP.
    2. US intergenerational debt.
    3. Condition of US banks generally (ABX, CDO's, Level 3 assets etc) that have created the need for unprecedented Fed and Treasury actions, negative nonborrowed reserves for the first time in history, etc.
    4. Negative real interest rates
    5. Ongoing credit writedowns and the effect of leverage working in reverse in the credit markets
    6. Bank failures and the fact the FDIC has recently asked for a raise in insurance premiums

    I really am interested to know what the long-term dollar-bullish factors are, and how the dollar gets around these long-term structural problems. TIA.
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  •  
    Aug 20 08:57 AM
    The dollar is way above its moving average, and as most know, the further it climbs the more it will fall. The points above are all well-taken, and you could also say what about the economy as a whole? Throw in Iraq, Afghanistan, Georgia, Poland's signature of the missile shield agreement, what's next for Ukraine, the election, oil? Markets are down 12-14% this year, so a catalyst is needed to get things back on track.

    As a (former) gold bug, it seems that the sentiment during pullbacks is that no cares about gold. It's these times when gold bugs get the jitters -- when the expectation is that gold will sky rocket, but people are not buying. This is a definite case of deflation: After significant money pumping from monetary policy by the Fed, money is pulled back and people cut their expenses (high gas prices are killing families), and there is significantly less buying. The big money also jumps somewhere else. What I would like to know is where is the money going. Yesterday if you tracked MTU (Mitsubishi Bank-->huge loans to China), TSM (Taiwan Semiconductor), YUM (global foods), they were all down significantly. This rules out money jumping to several example global stocks, although more detailed analysis is probably warranted. Maybe those with a crystal ball know the answer.

    Reply | Link to Comment
  •  
    Aug 20 12:41 PM
    "our fiat doesn't suck as bad as their fiat. Some cause for celebration!"

    Guess what... that is what makes currency markets move... don't like it? go buy some gold and sit on it.

    "The dollar rally was triggered by timely intervention against an oversold condition. The market manipulators (I think they call them "Market Makers") have access to enough trading position information, in fact they have access to ALL of it now that it is computer-based, that it should be an easy feat for them to determine the size and timing of an intervention to induce a short squeeze."

    Do you honestly think that there is a coordinated effort of what you call a 'market maker' to minipulate prices? you have obviouly never spend any time on a FX desk.

    "intervention&quo... - what the heck are you talking about.. there has been no intervention (other than verbal) to support the USD.

    what about the fact that the US earns roughly the same return on its FDI that the rest of the world earns on the FDI in the US? (mostly invested in goverment fixed income).

    so to make a long story short, i am not saying i know what is going to happend with the EUR/USD fx rate. Purchasing Power Parity dynamics would have the EUR off by another 10-20%, but again.. that isn't a great way to trade currencies.

    Bottom line, i know what i don't know - fx rates are largely a coin flip in the short / medium term. Take a look at the track record for any 'currency strategist' that employ the same 'sound' reasoning that you do. it sucks.

    Reply | Link to Comment
  •  
    Aug 20 07:23 PM
    onzilla,

    I know what I don't know, too. And that's why I've been trying to get someone to answer the questions. I see that you didn't even attempt it, I wish you had, because I really want to know what the outlook is for the USD long term.

    If your point regarding "market makers" is that there is so much trading in the dark pools that analysis of overall positions would be difficult, you may have a point. But I don't believe that the declaration of the "Protected-19&quo... wasn't timed to induce a short squeeze. I'm not that naive.
    Reply | Link to Comment
  •  
    Aug 20 09:23 PM
    My advice, for what it is worth, is do the opposite to Kathy Lien and you should make a fortune. Kathy has been telling us for months that the dollar's fortunes are about to improve; unfortunately not so, the recent rally was a short term blip, the long term trend is still down against all major currencies apart from the pound sterling. The pound is about to continue its long-term decline, particularly against the dollar, while the Euro will replace the dollar as the world's reserve currency. Euro short-term government bonds are therefore a good safe-haven for equity investors: wait patiently while the storm blows over.
    Reply | Link to Comment
  •  
    Aug 20 09:28 PM
    My advice, for what it is worth, is do the opposite to Kathy Lien and you should make a fortune. Kathy has been telling us for months that the dollar's fortunes are about to improve; unfortunately not so, the recent rally was a short term blip, the long term trend is still down against all major currencies apart from the pound sterling. The pound is about to continue its long-term decline, particularly against the dollar, while the Euro will replace the dollar as the world's reserve currency. Euro short-term government bonds are therefore a good safe-haven for equity investors: wait patiently while the storm blows over.
    Reply | Link to Comment
  •  
    Aug 20 09:52 PM
    onzilla:

    seekingalpha.com/artic...

    "Investors in the U.S. have responded positively to a firmer U.S. dollar, says Merrill Lynch North American economist David Rosenberg, but there is a darker side to the story.

    Mr. Rosenberg said in a research note that the rising dollar has likely had an impact on commodity markets and the recent drop in oil prices, a situation that investors have welcomed. “There is no doubt that the decline in oil prices is good news from a margin-supporting standpoint, as well as helping put at least a tentative floor under consumer confidence levels,” he said. Mr. Rosenberg added that a decline in commodity prices and a stable–to-firm U.S. currency are bright developments – especially since they have contributed to lower inflation expectations.

    However, he noted that one of the main reasons for the rise in the U.S. dollar is that economic conditions outside the U.S. have been deteriorating, with real GDP contracting in Japan, Germany, France, Italy and Hong Kong. “We also know that Canadian GDP contracted in the first quarter with little bounce in the second quarter.”

    The economist noted, though, that the share of U.S. corporate profits dependent on the dollar and domestic demand overseas recently hit an all-time high of 25%. “This heavy reliance on the global economy, in turn, leaves the earnings outlook more vulnerable to shifts in economic conditions than ever before.”

    It is conceivable, he added, that a global slowdown could see the foreign segment of U.S. profits decline by as much as 20% year-over-year. And with no clear indication that the U.S. housing and financials markets have bottomed in the U.S., "it’s a possibility that corporate profits could decline another 25-30% from here.”

    “This isn’t our forecast, but we believe it is conceivable – and much more likely that the current consensus forecast of an increase of 23% for S&P 500 earnings.”


    So maybe is DOES actually matter that the dollar rise is merely based on the dollar not sucking as bad as the Euro, and only so right now.
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  •  
    Aug 21 04:53 AM
    long term helps for usa: uaw is dying and race and gender and national origin quotas will eventually be outlawed.
    Reply | Link to Comment
  •  
    Aug 21 05:01 AM
    you do realize that the dollar moved very fast upward. i have yet to hear any argument to support that rapid of movement which make sense.

    i believe the world banks moved in concert to re-price the dollar. end of story.
    Reply | Link to Comment
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