US Dollar Update (by Leaf_West)

By -

LA_04 The US$ is often pointed to now by market pundits as a type of weather vane for their assessment as to the "risk-on" trade.  The thought is that the US Federal Reserve is debasing the US$ and all of the hedge funds in the world are piling on in a carry trade where they leverage up their Funds and bet on the US$ declining.

One of their favorite trades is to invest in any and all US$ priced commodities … gold, silver, oil, grains etc.  Trades never go on forever in straight lines however, and even if you believe in a thesis behind a "forever" declining US$ it pays to keep your eye on the short-term over-sold/over-bought nature of the US greenback.


I am a big believer in watching for divergences as the first warning sign for possible pauses/ends to trends.  One of my favorite internal measurements is the Money Flow Index ("MFI").  The MFI is an oscillator that uses both price and volume to measure buying and selling pressure.

Created by Gene Quong and Avrum Soudack, MFI is also known as volume-weighted RSI.  MFI starts with the typical price for each period.  Money flow is positive when the typical price rises (buying pressure) and negative when the typical price declines (selling pressure). A ratio of positive and negative money flow is then plugged into an RSI formula to create an oscillator that moves between zero and one hundred.  As a momentum oscillator tied to volume, the MFI is best suited to identify reversals and price extremes in conjunction with other signals.

The following charts are examples of divergences ("warning bells") at previous swing points in the US$ during 2010 (via the US$ ETF "UUP").

UUP_April1, 2011_01

UUP_April1, 2011_04

UUP_April1, 2011_05

Current Chart:

UUP_April1, 2011_06

Note how we have just broken the down trend line the past couple of days and that we are in the process of testing the US$'s low.  Also note how price dipped right into the rainbow-colored MOB (Make-or-Break) target drawn off of the Nov 2010 swing low.

I like getting long the UUP on a break of the $21.93 level.

Public Opinion of the US$

Sentiment Trader does a great accumulation of various public opinion/survey polls for currencies, commodities, equities, bonds etc.  They combine these surveys every Wednesday and the result is their own "sentiment" survey.

UUP_April1, 2011_03_SentimentTrader

The theory behind this indicator is that when the public reaches a consensus of opinion, they are usually wrong – they get too bullish after prices have risen, and too bearish after they have already fallen.

Because of that tendency, you very often see extremes in opinion right before major changes in trend.  When the public reaches a bullish extreme – a great majority thinks prices will keep rising – then you most often see prices decline going forward instead.   And when they become too bearish, prices then tend to rise.

Using strict "overbought" and "oversold" levels tends to not always work very well so Sentiment Traders' Opinion Charts use a relative measure of extreme, that being 1.5 standard deviations from a one-year moving average.  So when Public Opinion moves above the red dotted line in the chart, it means that compared to other readings over the past year, we're seeing a statistically extreme value.  You also want to look at the absolute level of Opinion, too – if it's at 90%, then there's no question we're seeing an historic level of bullish opinion.  Watch for readings above 80% (or especially 90%) to spot those dangerous times when the public is overly enthusiastic about a commodity/currency.

Conversely, when Public Opinion moves below the green dotted line, then the public is too pessimistic about the commodity/currency's prospects for further gains compared to their opinion over the past year. Looking for absolute readings under 20% (or especially 10%) can lead to good longer-term buying opportunities.

As you can see from last week's chart, public sentiment is at its lowest level since the important late-2009 US$ low.

Commitment of Traders

Finally, another Sentiment Trader chart I like to follow is the snap shot of the "Commitment of Traders" weekly report …  For those of you that are not familiar with the COT Report I will describe the important facts/features:

Each week, the Commodity Futures Trading Commission (CFTC) releases information on the long and short positions of three groups of traders in a couple of dozen different futures markets in a report known as the Commitments of Traders.

The three groups are determined by the number of contracts they are currently holding, and are described as follows:

Commercial Hedgers:

Commonly believed to be the "smart money", these traders are involved in the day-to-day operations of each commodity. They have an excellent handle on the underlying market, and it typically pays to follow their positions when they reach an extreme.

Large Speculators:

This group mostly consists of large hedge funds, and almost always take the opposite side of commercial traders. The are primarily trend-followers, and will accumulate positions as a trend progresses. When their positions reach an extreme, watch for a price reversal in the opposite direction of the existing trend.

Small Speculators:

These are smaller traders, composed mostly of hedge funds and individual traders. Again, they are mostly trend-following in nature and we often see price reversals (in the opposite direction) when they hit an extreme.

The CoT chart for each commodity shows a price chart of the commodity at the top, then Commercial Hedgers in green, Large Speculators in blue, and Small Speculators in red. The position of each group is determined by subtracting the number of outstanding short positions from the number of outstanding long positions.

For each of the three sets of traders, Sentiment Trader plots red and green dotted bands that are 2 standard deviations (a measure of extreme) away from the one-year average of the positions.  When the position exceeds the green band, it tends to be bullish for the commodity; when it exceeds the red band, it tends to be bearish.

UUP_April1, 2011_02_SentimentTrader

How to Interpret the Chart:

Commercial Hedgers are considered the smart money, so the green band for them is near the top of the pane.   When Commercials become net long to an extreme degree (i.e. over the green dotted band), then we should be looking for the price of the commodity to rise.  The opposite is true when they become so hedged that their position falls below the red dotted band.

Large and Small Speculators, by default, are considered "dumb money".  Prices tend to reverse when these traders reach an extreme, so when they become so net long that their positions exceed the red dotted band, traders should look for prices to decline, and vice-versa.

You also want to look at the absolute level of positions, too – if they're at their greatest extreme in several years (even if they may not exceed the trading bands), then there's no question you are seeing a notable event.

Note that during the financial crisis in 2008, the "smart-money" Commercial Hedgers were net short the US$ and the hedge funds were long the US$.  I believe that was due more to the financial crisis than it was a intermediate fundamental call on the US$.  The pivot highs and lows in the US$ the past two years have followed more normal patterns.

Currently, the Commercial Traders are long the US$ contracts at levels last seen right near the end of 2009 just before the swing low in the US$ that led to a 17% increase 6-month move higher.  Large Speculators are actually more short the US$ right now than they were right before that 6-month rip.  Small Speculators are virtually flat on their US$ bets.


Bottom Line:

Bottom line to me is that the US$ is likely near a low point and is favored to provide some type of bounce during the 2nd Quarter.  If that does indeed happen, it will have consequences for commodities, commodity-linked equities and equities in general.

Keep you heads-up and an eye on the US$ as we move forward here into the second quarter and the upcoming earnings season.

Cheers … Leaf_West

Visit My Blog