Pater Tenebrarum

About the Author Pater Tenebrarum

I'm an independent analyst and have been involved with financial markets for 31 years. I write economic and market analyses for independent research organizations and a European hedge fund consultancy. I'm the main author of the blog 'Acting Man', which presents articles on the markets and the economy, a mixture of commentary on current events as well as economic theory and history from an Austrian school of economics viewpoint.

Is the Dollar’s Correction Already Over?

Between the summer of 2014 and its recent peak in March this year, the US dollar index was a one-way street – a blow-off like move that mainly mirrored the equally relentless decline in the euro, which has been suffering from the ECB’s misguided ministrations. The euro has the by far largest weighting in the dollar index (nearly 58%). In the meantime, euro area money supply growth has begun to significantly exceed US domestic money supply growth (year-on-year growth in money TMS: euro area 12.4%, US dollar 7.5%) and interest rate differentials have turned in the dollar’s favor as well, so the revival of the dollar does make some sense from a fundamental perspective – only the size of the move has been a surprise. Recently the dollar has gone through its biggest correction since the rally began. Below we will take a look at a wide range of relevant positioning and sentiment data to illustrate where things now stand.

1-DXY cash index

The dollar index (DXY spot) daily. Given the size and relentlessness of the rally, it seems unlikely that the correction is already finished (this is to say, it is likely to become more complex and drawn out, even though the dollar is currently on a buy signal on the daily chart in terms of MACD and RSI). The declining 50 day moving average may provide resistance.

It has been quite fascinating to watch moves in the major currencies in the past few years, which are rationalized with what are ultimately only marginal differences in central bank policies and economic performance. Given the thin reed of reasoning behind these moves, their size and persistence has been quite a surprise. However, if one looks at various positioning data, it soon becomes obvious that speculative activity in currencies has soared in recent years, and when a big herd charges, large moves are probably inevitable. A fascinating aspect of this is also that positioning and sentiment extremes have so far proved far less meaningful in foreign exchange markets than in the past – this is to say, they haven’t worked very well as contrary indicators in the short term.

The recent pullback in the dollar has only slightly dented speculative enthusiasm for the currency so far. Currency futures are only a small microcosm of foreign exchange markets, but it is probably fair to assume that positioning in the futures markets provides an accurate reflection of market sentiment on the whole.


2-dollar index CoTs

Commitments of traders in dollar index futures, long term (large speculators in red, commercial hedgers in blue). The net long position of speculators has declined in the recent pullback, as those buying late in the rally have likely been stopped out. Speculative positions have reached the largest extent in the history of this futures market between June 2014 and Q1 2015.

Below is a close-up of the net commercial hedger position (the inverse of the total speculative net position), that shows more clearly how big these positions still are after the dollar’s recent pullback:


3-dollar CoTs-hedgers

The above chart shows the net short position of commercial hedgers, i.e., the inverse of the total net speculative position (big and small speculators combined). Positioning remains far from “neutral”

The Rydex fund family offers both a “strong dollar” and a “weak dollar” fund, and here we find a more pronounced pullback by dollar bulls. They have yanked a lot of money from the “strong dollar” fund since March. However, dollar bears seem to have become even more discouraged, as the ratio between the assets held by the two funds remains at a huge 30.52. In fact, very little money remains the “weak dollar” fund these days, as it has recently suffered an acceleration in outflows. These funds essentially reflect retail trader sentiment, which tends to be more volatile than big speculator sentiment.


4-Rydex strong dollar



The Rydex “strong dollar” fund experiences large outflows after its assets increased by almost 85% in the final leg up… 


5-Rydex dollar bear assets

… but dollar bears have capitulated completely at the same time

We would summarize small trader sentiment on the dollar as follows: dollar bulls have begun to wonder if they haven’t been a tad too bold when they increased their exposure by some 85% in the final week of the rally, but dollar bears have in the meantime joined the “extinct species” list.

In addition to these positioning data, sentimentrader also offers a special measure of sentiment called the “optimism index” or “Optix” for short, which combines the results of the most prominent sentiment surveys (Market Vane, Consensus Inc, DSI, etc.). Not surprisingly, there has been a pullback in this indicator as well, which previously spent a surprising amount of time between roughly 80 – 90% bulls. Given the fact that it is calculated as a combined index, the record reading of 91% bulls that has been reached twice (in January and March 2015) was certainly an eyebrow raiser. By comparison, the highest Optix reading reached in silver right at the peak of its blow-off rally in April 2011 was 84% bulls. Prior to attaining this high bullish consensus reading, the silver price rallied from $9.35 to $48, i.e., roughly 400%. It obviously took a far smaller move in the dollar to reach an even greater bullish consensus.

Not surprisingly, the dollar’s Optix reading has fallen back into neutral territory in the course of the recent correction. However, what is most interesting about this indicator is the fact that it has historically shown a tendency to move from one extreme to another and back again. This is a factor arguing in favor of a bigger and/or more complex correction in the dollar once the current short term rebound ends.


6-Dollar OPTIX sentiment

The dollar optimism index: as can be seen, it has a tendency to fluctuate between bullish and bearish extremes. Prolonged extremes in bullish or bearish sentiment tend to at least produce sizable counter-trend moves

Euro and Yen Positioning

The recent changes in the net speculative position in euro futures mirror those in dollar index futures. In other words, speculators have covered a little of their previous record net short position, but overall the position remains close to the high end of its historical range. Speculators are still about as bearish on the euro today as they were at the height of the crisis during which its very existence was coming into doubt.


7-euro cots

The speculative net short position in euro futures recedes, but remains at a historically very high level

The positioning changes in euro futures aren’t especially noteworthy, as they are essentially in line with what one would expect to see during a short term rebound. Positioning in yen futures is however quite interesting at the moment. Big and small speculators seem to have a slight difference of opinion at the moment. The yen has recently weakened again, once again approaching lows that have been tested twice already, in December 2014 and March 2015. Interestingly, big speculators have decreased the size of their previously very large net short position quite noticeably (from well over 100,000 contracts net to around 22,000 contracts net), while small speculators currently hold a net short position that is more than twice as large, and quite close to its previous record high. Apparently the expectation is that another major breakdown below the lateral support level shown in the chart below is imminent:


8-Yen, daily

The yen has gone sideways since December, but small speculators in yen futures expect the lateral support line shown above to give way

In the chart below the net position of small speculators (non-reportable positions) is indicated by the grayish line. Currently small traders are net short roughly 49,000 contracts compared to a net short position of just 22,000 contracts held by big speculators:


A difference of opinion between big and small speculators emerges in the yen

The fundamental case for a further decline of the yen against the dollar is currently a lot weaker than the case for a decline in the euro. This is mainly because money supply growth in Japan has been fairly tame, in spite of the BoJ’s “QQE” operations. Note though that Japan’s true money supply data may have to be revised in the future, as it has turned out that the demand deposits of all sorts of financial companies are excluded from M1. The cash deposits of non-bank financial institutions are undoubtedly part of the money supply though (banks hold their cash assets in the form of reserves with the central bank, and these are rightly considered as being “outside” of the economy and therefore should not be counted as part of the money supply).

We have only recently been made aware of this issue by Michael Pollaro, who calculates the true money supply statistics of several major currency areas (see links on the right hand side). At the moment we are not sure yet whether this will necessitate a significant revision of the data, but we will report back on this as soon as we know more. Even so, it is clear that through most of the the time during which the BoJ has been trying to inflate, Japan’s commercial banks have actually lowered the amount of outstanding bank credit, and hence have caused the amount of fiduciary media in the economy to decline (fiduciary media = demand deposits not covered by standard money or bank reserves). We expect therefore that even after a revision, Japan’s true money supply growth will still clock in at a lower rate than that of the euro area or the US.

As to the positioning data discussed above, the standard expectation would be that big speculators are more likely to be correct than small speculators, and their caution may therefore be a sign of an impending trend change in the yen. Note however that this is obviously not a hard and fast rule.

Bonus Chart – the Ruble

Since hitting a panic low in mid December of 2014, the Russian ruble has been one of the strongest currencies in the world (we have extensively discussed the ruble and the opportunity it likely represented here, here, hereand here). The last time we revisited the subject, we felt that it was probably time for a correction, but the ruble has actually rallied a bit further since then. Since the panic low on December 16 2014, it has risen by an astonishing 56% (the ruble is traded in rubles per dollar, so a stronger ruble appears as a decline on the chart below – the percentage we mention refers to the inverted version of this chart, i.e. it isn’t expressing the percentage decline in the dollar vs. the ruble, but the rally in the ruble vs. the dollar):




The Russian ruble and WTI crude oil (July 2015 contract, left hand scale). Divergences between the ruble and crude oil prices are often a tip-off regarding the next move in the currency – as demonstrated between December and February

As we noted in our previous missives on the topic, emerging market currency panics and recoveries always seem to follow the same pattern – and the ruble has once again borne this out. Invariably, the news are almost uniformly bad when the time to buy has arrived, which is why one needs to step back from the hysterical headlines of the day and try to look at things as objectively as possible.

The ruble’s recent strength is all the more noteworthy as it is even stronger in terms of various currency crosses given the dollar’s rally (even with its recent pullback, the dollar index is just 3% below its March peak). European investors who bought Russian stocks and bonds near the height of the panic have already more than “made their year” by now, not only due to the stronger ruble, but also due to the high dividends and yields these instruments sport. Especially bonds turned out to be a great bet, as it was e.g. possible to lock in a yield-to-maturity of more than 16% in Russian 10-year government bonds late last year, which has in the meantime declined to 10.6% (it seems this is already a good time to take profits actually).


Obviously, we don’t know how far exactly the most recent rebound in the dollar will go, but from a technical perspective we would expect it to top out slightly below the March peak, or perhaps after retesting the peak (it is almost certain that sentiment, positioning and momentum will all diverge against the March peak should it be retested) and thereafter resume its correction. This doesn’t necessarily mean that there will be a longer term trend change. However, even if the dollar’s rally is ultimately fated to continue, it seems to us that the big advance from mid 2014 requires more extensive corrective action before it can be expected to resume in earnest. The passage of time may prove to be more important than the depth of the correction in terms of price, but that remains to be seen.

There is still a wild card in the form of Greece – should it default and exit the euro, the euro could well come under additional selling pressure. A Greek exit from the euro strikes us however as somewhat less probable than a continuation of the “extend and pretend” scheme that has been in place up to now.

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