Data Brief - Will The Dollar Disappoint Again?

Will The Dollar Disappoint Again?

Saturday, May 3, 2008

Late Friday, there was an article posted on Bloomberg noting that "futures traders are betting for the first time since December 2005 that the dollar will gain against the euro." That is indeed true, as we'll discuss in a moment.

First, I wanted to touch on something else mentioned in the article. The journalist asserted that part of the reason why the U.S. Dollar has rallied against the Euro was that "the yield advantage of two-year German bunds over comparable-maturity Treasuries has decreased..., making dollar- denominated assets more attractive to investors."

Journalists always have to assign a cause to whatever moves happen in the market, no matter how small or spurious. So let's do a quick check to see if the relationship between short-maturity Treasury Notes and German Bunds has a high correlation to movements between the Dollar and the Euro.

The chart below shows the USD / EUR cross rate (as the orange line moves down, the Dollar is weakening against the Euro) along with the spread between the yield on Notes and Bunds (as the white line moves down, Note yields are dropping against Bund yields).

The bottom pane shows a rolling 52-week correlation between the two. If the journalist's assertions are valid, then that correlation should stay consistently positive (i.e. green).

Source: Bloomberg

The correlation has been hit-and-miss over the history of the Euro, but over the past couple of years the correlation has been positive, and mostly strong. Over the past six months or so, the rolling correlation has been exceptionally high at 0.95 or higher. So it seems as though the recent narrowing of spreads between Notes and Bunds could have something to do with the Dollar strengthening.

That's fine, but I'm not too interested in "why"...I'm more curious about "what will be". Not that we ever know for sure, but we can take a look at the current sentiment picture to see what may be most likely.

So let's take a look at those futures traders mentioned in the Bloomberg article. The chart below shows the Euro versus the net position of large speculators in Euro futures. This is part of the chart we update each week in the Commitments of Traders section of the site.

As the article noted, speculators have swung to a net short position of more than 20,000 contracts. That's one of the largest we've seen since the introduction of the contract.

If we include small speculators, who are less of a force but who also dropped to a near-record net short position last week, then the total amount being bet against the Euro by speculators is eclipsed by only a few weeks in 2005 as the currency was bottoming.

If you follow the C.O.T. data at all, then you know that if large speculators are short, and small speculators are short, then the only other part of the equation is commercial hedgers (aka "the smart money"), who must be long. And indeed they are, to the greatest amount since 1999, other than several weeks in late June / early July 2005.

We could stop there and just assume that sentiment on the Euro is too negative, and thus likely to rally. But I want to take a look at a few more things to try to determine if a trade might be in the offing.

One of the other sentiment charts we post is the Public Opinion for the Euro. This is created by weighting several different sentiment surveys that cover a broad swatch of investors and traders across the country. We've found that most of these sentiment surveys have an exceptionally high correlation with each other - when one group gets bullish, most of the others do too.

In contrast to the C.O.T. data, which shows the public being way too pessimistic on the Euro, the Public Opinion indicator isn't nearly as extreme. In fact, it's still in "too bullish" territory, in the process of coming down from an optimistic extreme over the past few weeks. The best times to bet on a Euro rally have been when the Public Opinion has dropped down to 40% or below.

Instead of looking just at the Euro, we can also take a look at the U.S. Dollar. The largest component (by far) of the Dollar Index is the Euro, so a rising Dollar Index will almost certainly coincide with a falling Euro and vice versa.

You can take a look on the site for the C.O.T. data on the Dollar, as well as the Public Opinion, so I'm not going to re-publish those here. Both of them are pretty neutral.

Instead, I want to go over a few much lesser-known indicators to see what they're telling us. First, let's look at total assets in the Strong Dollar Fund (RYSBX) offered by the Rydex family of mutual funds. When these guys and gals try to jump on a trend, it's usually late in the game.

Clearly, these folks have boarded the strong Dollar train, as assets in the fund have rocketed from $35 million in early April to nearly $100 million as of Friday. These traders don't have the best record at timing moves in the Dollar or most other assets, as we can see from the chart. Previous spikes in assets have come just as the Dollar was about to roll over again.

Another fund geared towards individual investors is the PowerShares US Dollar Bullish Fund (UUP), a vehicle that rises when the Dollar does. Take a look at the volume in the fund over the past several days:

Another group we can take a look at is the "big money". Last week, I wrote about the big money poll as conducted for Barron's magazine, and concluded that as far as their overall bullish/bearish leaning for stocks in general, we couldn't really consider them either smart money or a contrary indicator.

Below is the history of their opinion on the Dollar. The green line shows what percentage of respondents in the poll thought that the Dollar would rally over the next 6-12 months; the red line shows the number that though the Dollar would fall.

In the latest survey, there was a huge surge in positive opinion, with more bulls than bears for the first time since the fall of 2000. The fall of 2000 happened to coincide with a major peak in the Dollar, so that wasn't a good call on their part, but they've been net bearish (and correctly so) for the past several years.

Their moments of peak bearishness, in the fall of 2003 and spring of 2006, weren't especially good contrary indicators. The Dollar did some chopping around, rallying slightly soon afterward, but these guys were right on in being very bearish. So while it's tempting to suggest that their recent surge of buying interest is another contrary indicator, I wouldn't concur, and in fact I would even suggest it's possibly a good sign for the Dollar.

Other looks at the data, such as seasonality in the Euro and the Dollar, and short interest in the CurrencyShares Euro Trust (FXE), were inconclusive and didn't add anything to a potential outlook.

So when we put this all together, does it look like the Euro will resume its multi-year uptrend anytime soon? Well, the fact that speculators have become so heavily short, so quickly, is a good sign - they should quickly cover those shorts and go back to long if it looks like Euro is going to rally. And the fact that small-trader sentiment towards the Dollar has become quite bullish also suggests that perhaps the Dollar will take a breather and the Euro should rally.

But the Public Opinion indicator for the Euro is holding me back, as is the big money poll from Barron's. I'll be looking for perhaps a shorter-term bounce in the Euro during the next couple of weeks due to the recent about-face in sentiment towards the Euro and Dollar, but I'm not counting on a major sustained run to new highs just yet - I'd want to see Public Opinion become much more extreme for both currencies first.