Best of the Week
Most Popular
1.UK House Prices Momentum Crash Threatens Mini Bear Market 2017 - Nadeem_Walayat
2.Perfect Storm - This Fourth Turning has Over a Decade of Continuous Storms to Come - James_Quinn
3.UK House Prices Momentum Crash Warns of 2017 Bear Market - Video - Nadeem_Walayat
4.Billionaire Investors Backing A Marijuana Boom In 2017 - OilPrice_Com
5.Emerging Markets & Basic Materials Stocks Breaking Out Together - Rambus_Chartology
6.Global Currency Reserve At Risk - Jim_Willie_CB
7.Gold and Silver: Your Stomach Is Probably Wrenching Right Now - The_Gold_Report
8.Warning: The Fed Is Preparing to Crash the Financial System Again - Graham_Summers
9.Basic Materials and Commodities Analysis and Trend Forecasts - Rambus_Chartology
10.Discover Why A Major American Revolution Is Brewing - Harry_Dent
Last 7 days
Gold is a coiled spring… the breakout is here, fundamentals are in place, technicals are compelling - 20th Aug 17
A Midsummer Night's Dream: Buy Gold and Silver - 20th Aug 17
Gold Mining Stocks 2017 Fundamentals - 20th Aug 17
EIA Weekly Report and Crude Oil - 19th Aug 17
4 Insights for Adjusting Your Portfolio in a Rate-hike Environment - 19th Aug 17
Gold Direction Indicator - 19th Aug 17
Historical Inevitability and Gold and Silver Ownership - 19th Aug 17
You Are Being Lied To About “Low” Gold Demand - 19th Aug 17
This is Why Cocoa's Crash Was a Perfect Setup - 19th Aug 17
Gold, Silver Consolidate On Last Weeks Gains, Palladium Surges 36% YTD To 16 Year High - 19th Aug 17
North Korea Is Far From Being Irrational… It Has A Plan - 18th Aug 17
US Civil War - FUNCTIONAL ILLITERATES TRYING TO ERASE HISTORY - 18th Aug 17
Bitcoin Hits New All-Time High Over $4,400 As It Catches Paypal In Total Market Cap - 17th Aug 17
3 Psychological Ingredients behind Great Web Content - 17th Aug 17
The War on Cash - Rogoff, Orwell and Kafka - 17th Aug 17
The Stock Market Guns of August, Trade Set-Up & Removing your Rose Tinted Glasses - 16th Aug 17
Stocks, Bonds, Interest Rates, and Serbia, Camp Kotok 2017 - 16th Aug 17
U.S. Stock Market: Sunrise ... Sunset - 16th Aug 17
The Next Tech Crash Could Delay Your Retirement by a Decade - 15th Aug 17
Gold and Silver Precious Metals Nearing Breakout - 15th Aug 17
North Korea Showdown: Pivotal Market Turning Point - 15th Aug 17
Tech Stocks DOT COM Bubble Do-Over? - 14th Aug 17
Deep State Conspiracy or Chaos - 14th Aug 17
From the Trans-Atlantic Axis and the Trans-Asian Axis - 14th Aug 17
Stock Market Intermediate Correction Underway - 14th Aug 17
The Islamic State Jihadi Pivot to Asia - 13th Aug 17
Potential Pivots Upcoming for Stocks and Gold - 13th Aug 17
North Korean Chinese Proxy vs US Military Empire Trending Towards Nuclear War! - 12th Aug 17
Gold Stocks Coiled Spring - 12th Aug 17
Neil Howe: The Amazon-Walmart Rivalry Will Determine the Future of Retail - 12th Aug 17
How to Alton Towers Half Price Discount Entry 2017 and 2018, Any Time, No Pre-Booking! - 12th Aug 17
Top 3 Technical Trading Tools Part 2: Relative Strength Index (RSI) - 11th Aug 17
What Makes Women Better Investors - 11th Aug 17
Crude Oil Price Precious Metals Link in August - 11th Aug 17
Influencer Marketing Predictions All Businesses Should Take Into Account - 11th Aug 17
Really Bad Ideas - Government Debt Isn’t Actually Debt - 10th Aug 17

Market Oracle FREE Newsletter

3 Videos + 8 Charts = Opportunities You Need to See - Free

Stock Market SPX Driving U.S. Dollar Trend

Stock-Markets / US Dollar Jun 25, 2010 - 10:51 AM GMT

By: Zeal_LLC

Stock-Markets Best Financial Markets Analysis Article

So far this year, the US dollar has enjoyed a strong performance.  Traders carefully watch this flagship currency since its fortunes affect virtually everything, from world-trade balances to global financial markets to commodities prices.  Given the dollar’s universal impact, understanding its drivers is essential for gaming all kinds of markets.


Today conventional wisdom attributes the dollar’s recent strength to the brutal selloff in the euro, its primary competitor.  And this is certainly logical.  The US Dollar Index (USDX) is the primary tool traders use to track the dollar’s progress.  And the euro dominates this key metric at 57.6% of its weight.  So the dollar, which really means USDX in most traders’ minds, is heavily affected by the euro.

But what if this causality is backwards?  What if the dollar isn’t strong because the euro is weak, but the euro is weak because the dollar is strong?  Identifying the prime mover in this relationship is exceedingly important for traders.  If the driving force behind this year’s wild currency moves is emerging from the dollar side rather than the euro’s, it radically changes trading outlooks in all kinds of markets.

Europe has all kinds of problems today, the chickens coming home to roost on big-government socialism and out-of-control government spending.  It is tragic to see Washington asininely dragging the US into this same socialist cesspool today given Europe’s woes.  And if the Europe situation truly is the driver of the dollar’s recent strength as nearly everyone assumes, its rally could continue for a long time to come.

But amazingly given the stellar popularity of this thesis, the market action really doesn’t support it very well at all.  If you carefully study the dollar’s price action, this currency is marching to the beat of a different drummer than the euro.  Its primary driver actually lies outside the currency realm entirely.  The fortunes of the US stock markets have utterly dominated dollar behavior over the past couple years!

I know this sounds heretical at first, but it is eminently logical and demonstrable.  The US stock markets are best measured by their flagship S&P 500 index (SPX), and its performance is inarguably the dominant psychological force in the entire world’s financial markets.  When stocks are rising, people feel better about the economy and spend more.  This includes investing.  But when stocks are weak, people pull in their horns even if they have no direct exposure to the stock markets.

SPX-driven psychology affects virtually everything.  The collective economic outlook, consumer confidence, consumer spending, house sales, business expansion, and almost all economic activity are heavily colored by the state of the US stock markets.  When the SPX is rising people feel good and tend to spend more and grow the economy, and vice versa.  The psychological wealth effect the stock markets generate is immensely powerful.

And even the massive global currency markets are not immune to this stock-market wealth effect.  The ultimate case in point was the USDX’s behavior during the infamous 2008 stock panic.  This first chart superimposes the USDX over the SPX over that incredibly tumultuous period.  In order to understand why the dollar is rallying in 2010, you first have to understand what it did during the stock panic and why.

Back in April 2008, the USDX hit an all-time closing low.  And since the USDX has been around since March 1973, all-time is a big deal.  Since its secular bear started in July 2001, this leading currency had fallen a mind-blowing 41%!  You could hardly even give dollars away back then, central banks were trying to diversify away from them.  Meanwhile the euro, which nearly everyone assumes is going to zero today, was trading near $1.60.  Throughout the first half of 2008, the USDX lingered near all-time lows.

Then in July 2008, something unprecedented drove great fear.  The once invulnerable US mortgage giants Fannie Mae and Freddie Mac teetered on the edge of bankruptcy.  In a single month their stocks had plummeted 72% and 78%!  Large investors around the world who owned trillions of dollars worth of mortgage-backed bonds watched nervously.  Would they get their principal back if the GSEs failed?  Rather than holding and hoping, they rushed to sell GSE bonds and buy much-safer US Treasuries instead.

Before this GSE crisis that cascaded into a full-blown bond panic emerged, the USDX was languishing at just 0.5% over its all-time low in mid-July 2008.  But bond-panic fear drove a massive dollar rally as flight capital rushed to the relative safety of US Treasuries.  Of course foreign investors had to buy dollars first.  After bond fears started to abate in early September, the USDX quickly collapsed back down.

But then the infamous stock panic slammed into already-fragile global markets.  At its climax in October 2008, the SPX had plummeted 30% in a month!  It was effectively unprecedented, the first true panic in 101 years.  This kicked fear into overdrive, spawning another utterly massive exodus of scared capital out of global stock markets and into cash (US dollars) and US Treasuries.  As a result of this stock panic following the bond panic, the USDX skyrocketed 22.6% higher in 4 months.  This was the biggest and fastest rally ever witnessed over such a span in this index’s entire history!

I called this “the panic trade” at the time.  Sell everything, buy dollars and Treasuries.  It crushed commodities, which are heavily dependent on dollar levels, and commodities stocks.  And even though the euro got massacred by this epic USDX rally, it wasn’t the euro that was driving the dollar buying.  It was raw fear, a stock-panic-driven flight from risky assets around the world and into safe-haven US dollars.  At least cash positions would preserve principal through the panic maelstrom.

Note above that the USDX topped on the exact days the SPX bottomed!  In fact, leading into the SPX lows in October 2008, November 2008, and March 2009, the dollar’s negative correlation with the US stock markets was uncanny.  Respectively the USDX hit new highs when the SPX hit new lows on 5 days, 2 days, and 5 days over these three major stock-market bottoms.  The US dollar was totally at the mercy of the stock markets’ fortunes, only surging when they were exceptionally weak.

If you were paying attention during that panic span, and who wasn’t, you well remember that the US dollar was hardly ever discussed.  All discourse was dominated by the sorry state of the US stock markets and the resulting economic fears that we were entering a new full-blown depression.  Pessimistic stock-market psychology drowned out everything else over that panic span, and the dollar was driven to trade in lockstep opposition to the SPX.

In this chart, the visual evidence of this inverse correlation is irrefutable.  Not only were USDX highs exactly synchronized with SPX lows, but in periods when the SPX was weak the dollar was strong and vice versa.  The panic trade drove an incredibly-tight inverse correlation.  In fact, from mid-July 2008 when all this fear-driven dollar-buying action started to early-June 2009, the statistical negative correlation was so high that the USDX and SPX sported an r-square of 79.8%.

In other words, 80% of all the daily trading action of the US Dollar Index over this wild panic span was directly explainable mathematically by the SPX’s own.  Sure, there were exceptions from time to time when the dollar’s own drivers temporarily overrode the SPX’s dominating psychological influence.  In March 2009 for example, the USDX plunged and then recovered on news the goofy US Fed was starting to monetize US debt.  But in general, the dollar action that awoke it from its bear slumber was utterly dominated by the SPX.

A month ago I wrote an essay chronicling the euro action over this panic time frame.  Naturally when the dollar was strong the euro was weak and vice versa.  But the causality was crystal-clear.  It wasn’t Europe fears that were driving US stock-market selling, but US mortgage-market fears.  And it wasn’t euro weakness that was driving the unprecedented dollar strength, but the surging dollar that was hammering the euro.

The panic trade resulted from stock-market fear driving aggressive safe-haven dollar buying.  The euro was simply collateral damage.  This history is beyond argument, I doubt anyone could dispute it.  And it is incredibly relevant today because I suspect what we’ve seen in 2010 is a resumption of that famous panic trade.  This year, just like during the panic, falling stock markets are generating fear leading to dollar buying.  And the falling euro is the effect, not the cause as most traders now assume.

The strong inverse correlation between the USDX and SPX persisted into the summer of 2009.  While the US stock markets rallied powerfully between April and November, the supposedly mighty dollar sold off relentlessly.  In fact, by late November 2009 it grew heavily-oversold.  It had fallen to 0.92x its 200-day moving average, a level in the past from which major bear rallies erupted.  And another big bear rally was certainly due in late 2009, as I warned our subscribers about in early November.

Provocatively at those oversold late-2009 lows, the USDX was only 3.5% above its ultra-weak July 2008 levels where its stock-panic-driven rally started.  Over this same span, the SPX was 8.6% lower.  Heck, last November the USDX was only 4.0% above its all-time low from April 2008!  The strong-dollar crowd so vocal today conveniently forgets how pathetic the USDX looked for most of 2009 before its necessary and healthy bear rally erupted.  Without stock-market selling, the dollar couldn’t catch a bid!

That sharp bear rally in December 2009 was one of those periodic events where the USDX decoupled from the SPX to once again follow its own sentiment drivers.  But the dollar quickly worked off its oversold condition in a matter of weeks and soon started trending lower again as the SPX ground higher from mid-December to mid-January.  The USDX didn’t start surging again until the SPX started retreating in late January in what would become its biggest pullback (8.1%) of its entire cyclical bull to that point.

In early February 2010 when the SPX bounced, the USDX bear rally promptly stalled as expected.  If the SPX was driving the dollar most of the time, and it clearly was as we’ve seen in these charts, then flight capital shouldn’t flood into US dollars unless the stock markets were weak.  And indeed as the SPX surged between early February and late April, the USDX was largely flat and grinding sideways.

Why wasn’t the dollar weak with the SPX strong?  This February-to-April span saw the rise of the totally irrational euro-to-zero fears.  The vast majority of traders refused to see the dollar action within the past couple years’ context and instead arbitrarily assigned the euro primary-driver status.  And if you remember how overpowering the Europe woes were for market psychology between February and April, the dollar’s flatness is very damning.  If the USDX couldn’t rally in that perfect environment, can it even be in a bull?

And then in late April, the SPX started topping and rolling over.  In early May the Flash Crash erupted, sparking widespread fear.  The SPX was plunging in its biggest and first true correction of this entire cyclical bull.  Suspiciously, the USDX didn’t start surging again until the SPX started plunging.  It was a minor echo of the panic trade, sell everything else to buy dollars and US Treasuries.

Over the SPX’s 6-week correction span, it fell 13.7% while the USDX rocketed 8.7% higher.  Yet again the USDX peaked (near March 2009 panic highs no less) on the very day the SPX bottomed in early June!  Interestingly the negative correlation of the USDX and SPX over this correction was so powerful that they ran an r-square of 81%.  This is very close to what we saw earlier during the stock panic.  The primary driver of the USDX was not the flagging euro, but the plunging US stock markets.  This has been the case for nearly all of 2010.

Carefully examine the USDX’s trading action so far this year in this chart.  Note that nearly all its gains this year, on the order of 9/10ths, occurred in just two short spurts.  The first coincided nearly exactly with the sharp SPX pullback of late January and early February and the second nearly exactly with the sharp SPX correction between late April and early June.  2010’s vaunted dollar rally is nothing more than a temporary resurgence of 2008’s tired panic trade!  The dollar can only rally when the SPX is falling!

So the SPX is driving the USDX, what’s the big deal?  This contrarian perspective on prevailing causality radically changes our trading perspective going forward.  Consider the very-different outlooks driven by a euro-centric or SPX-centric worldview, especially if you are a commodities-stock speculator or investor.

If the conventional euro-centric worldview is correct, the US dollar could rally for a long time to come since Europe’s socialism-spawned debt problems aren’t going away anytime soon.  A higher dollar means lower commodities prices, and lower commodities prices mean weaker profits and hence lower stock prices for commodities producers.  The prevailing structural perspective on a Europe-driven dollar rally is actually pretty darned bearish for commodities stocks in the foreseeable future.  And this view also assumes Europe is driving the US stock markets lower, so it is bearish for the SPX as well.

But if the SPX retreats are the ultimate driver of the dollar’s strength, it changes everything.  As soon as today’s SPX cyclical-bull-within-a-secular-bear resumes, the dollar will start selling off again as flight capital exits dollars and Treasuries and returns to the stock markets.  A falling dollar will drive the euro higher, seriously reducing European financial concerns plaguing market psychology.  Commodities prices will surge on the dollar weakness, driving big gains in commodities stocks.  And of course all sectors will enjoy a nice boost as the broader stock markets rally.

Pretty wild, eh?  Your perspective on what is driving the US dollar’s rally this year can change your near-term worldview from bearish to bullish.  Trading strategies, especially for commodities stocks, shift 180 degrees depending on what is driving the dollar.  And as I suspect you’ll agree if you really take the time to digest the charts in this essay, it is the SPX that is driving the USDX.  Just like we saw during the stock panic.

At Zeal, we don’t accept conventional wisdom just because most people believe it.  We carefully study interactions between major markets to understand true causality.  In order to be a contrarian and buy low when others are scared and sell high when others are greedy, you can’t get caught up in mainstream market groupthink.  You have to think for yourself and listen to the markets themselves, not consensus.

While you probably can’t devote a lifetime to relentlessly studying the markets every day as we have, you can enjoy the fruits of our labors and resulting wisdom.  We publish acclaimed monthly and weekly newsletters analyzing the markets to look for high-probability-for-success trading opportunities.  We specialize in commodities stocks, and have been buying aggressively around the recent bargain lows.  Subscribe today!  Start listening to the markets, thinking for yourself, and building your own fortune.

The bottom line is this year’s US dollar rally has been driven almost exclusively by stock-market weakness.  This is a resurgent echo of the panic trade, sell everything to buy US dollars and US Treasuries whenever the stock markets are sliding and generating fear.  The moment stock selling abates, the dollar promptly starts falling (or rarely drifting sideways).  Stocks’ fortunes are the key to the dollar.

This widely-ignored causality has huge implications for traders.  As stock markets bounce and flight capital emerges from hiding in the dollar and Treasuries, the dollar will fall rapidly.  This will drive big surges in commodities prices since the world’s raw materials are still primarily priced in US dollars.  And of course higher commodities prices will lead to higher profits, and hence stock prices, for commodities producers.

By Adam Hamilton, CPA

So how can you profit from this information? We publish an acclaimed monthly newsletter, Zeal Intelligence , that details exactly what we are doing in terms of actual stock and options trading based on all the lessons we have learned in our market research. Please consider joining us each month for tactical trading details and more in our premium Zeal Intelligence service at … www.zealllc.com/subscribe.htm

Questions for Adam? I would be more than happy to address them through my private consulting business. Please visit www.zealllc.com/adam.htm for more information.

Thoughts, comments, or flames? Fire away at zelotes@zealllc.com . Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!

Copyright 2000 - 2010 Zeal Research ( www.ZealLLC.com )

Zeal_LLC Archive

© 2005-2017 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

Catching a Falling Financial Knife