Mighty Dollar Might be Cause For Concern

As the dollar trend higher international profits could be crimped.

Currencies tend to be the trendiest markets. I don’t mean in terms of teen age girls sporting handbags with a Japanese yen logo. Though Supermodel Gisele Bundchen did famously top ticked the Euro dollar in 2007 when she asked to be paid in Euro’s rather than U.S. greenbacks.

By trendiest I’m referring to the fact that currencies tend to move on macro forces that take years to play out. Once they start n a certain direction they tend to continue for long time period.

Right now it appears the rise of the mighty US dollar is the biggest trend in the entire world. It is a veritable tidal wave and massive trend that could last for years and implications across multiple markets.  The recent crash in oil, though mostly due to oversupply, is being exasperated by the stronger dollar.

The U.S. Dollar Index, which measures the dollar against six of the top currencies including the Euro and Yen, has gained some 12% in the just past six months. As the chart below show the dollar started breaking a decade long downtrend in early 2012. The move became more pronounced this past July when the Fed began to taper and recently accelerated at other Central Banks began their own asset buying programs.

US. Dollar Index

Screen Shot 2014-11-28 at 2.24.26 PM

Big Bull Market in Dollar…

The dollar bull is bigger than equities… bigger than oil… orders of magnitude bigger than gold… on and on.

To understand how big the dollar trade is, consider this: The USD is the other side of a carry trade measured in trillions of dollars. That is trillions with a “T.”

Some estimate the USD carry trade to run about three trillion. And the rising dollar means a great unwinding is at hand. Once again, look at the recent price action in oil and gold.

In tandem with its role as the world’s reserve currency, the US dollar serves as a “funding currency.” That means that the dollar is used all over the world to facilitate loans and leveraged transactions. Many emerging market economies, for example, will take out loans denominated in dollars rather than their own currency. The widely accepted nature of dollars makes the debts more liquid and palatable to international investors. Commodities, of course, are also priced in dollars. All over the world, transactions are made in dollars where a liquid “go between” medium is needed for parties dealing in less liquid home currencies.

…May Be Bad for Global Markets

A rising dollar, however, is the equivalent of a broad-blanket tightening of global credit conditions. It takes all the above effects and slams them into reverse.

A sharply rising dollar puts emerging markets in very grave danger, for example. It highlights the perils of borrowing in a currency other than one’s own. When the dollar rises, dollar- denominated debts suddenly become much more expensive in real payment terms, even as emerging market economies face economic slowdown and investor capital flight simultaneously.

This is the equivalent of a highly leveraged business suddenly seeing the real cost of interest payments rise, even as sales slow dramatically and credit lines are being yanked — all at the same time.

The United States is the wealthiest country in the history of the world. Its economy alone has long represented 25% of global GDP. In stock market terms, this makes the USA like an Apple (AAPL) , Microsoft (MSFT) or Google (GOOGL) in a world of small caps. As such, when the United States sends dollars out into the rest of the world — engaging in foreign investment, buying and investing on credit — that provides liquidity to the rest of the world.

This liquidity then “greases the wheels” of economic activity for the entire planet. No other single economy is large enough, dominant enough, or diverse enough to provide this essential role. The United States, via the dollar, and via the USA’s highly active investing and borrowing activities, is a sort of first and last resort liquidity provider for the global free market economy.

Most “dollar doomers” don’t understand the macro picture. They underestimate the inherent strength of the US balance sheet. They never realized that, compared to the assets, cash flows and intellectual property America holds on its books, along with its long list of superlative “superpower” advantages — military superpower, natural resource superpower, technology superpower, innovation superpower, real estate superpower, now energy superpower, on and on America’s national debt is about as onerous as a mid-sized car payment for an upper middle class family.

It is on these fundamentals the dollar should see a multi-year rally, possibly climbing 50% over the next three years.

Stock Implications

Nearly half of S&P 500 revenues come from overseas. Investors have been relaxed about US dollar damage prospects because ominous language has not yet shown up in official corporate outlooks. This is short-sightedness. Equity markets — particularly large cap US multinationals continue to bear the stamp of “dead man walking.”

In Reminiscences of a Stock Operator there is an anecdote about a market operator who says that, when he is walking down the railroad tracks and hears a train coming, he has the common sense to sidestep — and doesn’t even pat himself on the back for doing so.  The dollar is that train… and anyone with eyes and ears should be watching and listening for signs it is rolling down the tracks.

The dollar bull market may be the dominate theme for years to come. It will impact a multitude of markets, from stocks to commodities to bonds across the globe. We need to know the forces at work as we navigate the investment landscape going forward.

The Trade

The first and most obvious play on this trend is to simply get long the U.S. Dollar. I’m going to use the PowerShares US Dollar Bull (UUP) exchange traded fund as the vehicle of choice.

To limit my risk but maintain unlimited upside I’m buying call options. As this is a long term theme I’m using at at-the-money call option with a later dated expiration. Specifically;

-Buy June $23 calls at $0.75 a contract

With UUP trading at $23.40 a share these calls are slightly in-the-money.

This gives them a current delta of 0.75

The expiration date is June 20, 2015, or seven months from. This gives time for our theme to play out and reduces the negative impact of time decay.

— Steve Smith

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About the Author: Steve Smith