The US Dollar Bull Market is Alive and Well

If you think that the “bullish USD trade” is too overbought – well, you might have to rethink or at least try not to think too much. My feeling is that the “big” move in the USD we have witnessed over the last 6 months is only just the start of a major move and what appears overbought now will remain so for a considerable period of time.

If there is one thing I have learnt in my many years of trading currencies – we have little concept of what is over-bought or over-sold. Once a market starts trending it usually stays in a trending state a lot longer than the majority of traders can rationally imagine.

What do we need to create a long-term trend? A long period where trend trading didn’t work, the longer this non-trending period, the longer the trending period. To the average trader this may sound counter-intuitive – the more traders who don’t believe there will be a long-term sustainable trend the more sustainable the trend will be.

If we go back 6 months when I was writing right here saying that the risk/reward setup meant that we were getting long USD, this was mid last year and this is exactly the situation we had.

For some 5 years (from 2007 – 2014) any “trend” in the Dollar Index only lasted at best 6 months before reversing most of the previous gains. Then from the end of 2011 until mid 2014 (2.5 years) it went absolutely nowhere! I guess it was reasonably safe to say that by mid 2014 the vast majority of traders had thrown in the towel on the idea of the USD Index trending ever again! And just when enough traders had thrown in the towel guess what started to happen!

USD IndexUSD Index spot (2001-2014)

Yes, the USD Index has advanced by some 17% in the last 6 months but given that it essentially went nowhere in the 5 years prior, I think we have at least another couple of years before we have to contemplate “how much more upside is left in the USD”.

USD Index 2001US Dollar Index spot (from 2001 onwards)

From a longer term perspective, just look at the move in the USD Index from a very long term perspective, the move we have seen over the last 6 months, while steep, is nothing in the overall scheme of things. As you will see in the “fundamental” discussion below – it could be argued that there isn’t anything stopping the USD Index repeating what it did in the early-mid 1980s!

In fact Chris believes that we’re seeing an unwinding in sovereign debt markets beginning in emerging markets. Certainly we’re seeing incredible pressures in the Eurozone.

USD Index 1975USD Index spot (from 1975 onwards)

From a fundamental perspective let me give it to you straight – there is a shortage of USDs, this is essentially the result of a 10 year bear market (2001-2011) in the USD and relatively cheap rates. As part of this year’s Barron’s Round Table, Felix Zulauf gives a great succinct summary on the fundamentals of the USD:

The dollar was strong against every major currency in the world last year. That hasn’t happened in at least 25 years.

Mainstream economists are telling us that the dollar is strong because of growth differentials among countries, and an impending interest-rate hike in the U.S. They don’t understand the true reasons for the strong dollar.

The Federal Reserve, under Alan Greenspan and Ben Bernanke, pursued a monetary policy that kept interest rates too low. It weakened the U.S. currency, which became a funding currency around the world. Corporations issued dollar-denominated debt. According to the Bank of International Settlements, there is $9 trillion of dollar-denominated debt outstanding in the private sector around the world. That is the short position. Whatever the reasons for the recent firming of the dollar, the true firming eventually will occur when all issuers of dollar-denominated debt see their liabilities rise. They will have to hedge their positions and buy dollars, creating demand for the dollar.

At the same time, the current account deficit of the U.S., which is the way the U.S. supplies dollars to the rest of the world, has been shrinking in recent years. Therefore, there is a diminishing supply of new dollars.

So while the US current account deficit continues to narrow there is absolutely going to be a shortage of USDs. There is $9 trillion of dollar denominated debt outstanding, well considering that it took a number of years to build up this debt, it is going to take more than just a few months to unwind, more likely a couple of years at least. If the US Federal Reserve were to raise rates this year it sure wouldn’t help the cause, rather it would throw accelerant on the smouldering liquidity fire!

So our view is that we are only in the initial stages of a bull market in the USD. What is the best way to play the view? We recently published a detailed report on this.

One thing is for sure – in light of the Swiss franc drama, trading the spot market with leverage is a fool’s game. All it takes is one CHF type event and poof there goes all your funds no matter how well you did in previous years.

Our preference is to express a bullish view on the USD via options. The cost of options is still attractive. Below is the JPMorgan Global Currency Volatility Index (think of it as the VIX of currency markets). The red line is the current level which, if you take out the 2008 spike, is about normal or at least not expensive.

JPMorgan Global Currency Volatility Index

Last year we discussed a number of bullish options positions on the USD, most of which are up well over 100% (calls on the USD/JPY, USD/SGD, USD/CNH, puts on the NZD/USD, etc). These may sound like huge returns but we think the best is still yet to come as the USD is nowhere near a long-term top. Some, like the renminbi, are only just getting into gear:

USDCNYUS dollar against the Chinese renminbi (USD/CNY)

Sometimes the best thing to do is to sit on your hands and hold your positions. As Tom Petty once put it, “the waiting is the hardest part”.

Feel free to download our complimentary report on the US dollar bull market here.

– Brad

“The key to everything is patience. You get the chicken by hatching the egg, not by smashing it.” – Arnold H. Glasow


This Post Has 13 Comments

  1. Peter S.

    CapEx has been turning out some wonderful analysis recently. I should have been following and commenting these past months (as in the past), but here goes with a contrary possibility on this sure thing CNY short.

    About 80% of my income is paid in Renminbi so the benefit over the past 5 years (vs. the USD) will be wiped away if it now weakens greatly. Basically I agree with Brad’s, Tim’s and SovMan’s theory and am finally following this trade for hedging my exposure, but I do want to offer an alternative scenario and ask for open debate amongst the august folks here on CapEx……

    Yes, Chinese construction and lending is in a MASSIVE bubble. I see it out my window right now and every week as I travel through the major cities here. We’ve all read about ghost structures and I tell you it is true, and recently I am noticing even more cessation of projects. There are going to be haircuts, no doubt. SOE Banks, shadow lenders, provincial governments, developers and simple owners are going to be hit. I think that the way the Party and PBOC handle this inevitability is what should be considered though.

    Xi Jinping has been seriously rooting out corrupt officials and attempting to gain TRUST from the people. Most of the Chinese I work with, young and old, don’t believe it – yet. But some are beginning to tell me they are sensing new respect for their leaders and THEY ALL love his wife! I sense he might be building the political capital and power to bankrupt some really powerful people and not lose control. If so, what if China/BRICS/Associate Countries pull off something like the following to avoid being the next victim/patsy of insane, suicidal western CB policy, save face, exert leadership and set a new monetary path:

    – Announce a new Yuan/BRICS currency backed by gold, oil and USD
    – Make it freely convertible
    – Simultaneously announce creation/issuance of a sovereign pan-BRICS debt market
    – Require insolvent banks, lenders and major corporations to fund themselves from this new global market (while protecting the core banking system)
    – Adopt HK/Western type securities and property laws into the new BRICS banking/regulatory/governance center (Shanghai FTZ?), with full backing by all member nations

    Risky? Hell Yes! Unlikely? Probably. So that is why we hedge the CNY.

    BUT, if I was heading the PBOC/BRICS Bank I would sure be studying something like this rather than jumping like another lemming into the Western initiated currency war which will result in hyper-inflationary rubble anyhow……Why not attempt to somewhat MANAGE to the new system using the real asset cards/geopolitical power you have amassed?

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