Dollar Ready to Rally

The market theme during the past few weeks has been the fade of the Trump trade. And it’s not just recent weakness in certain stock sectors, such as commodity based cyclicals like U.S. Steel (X) and financials, that have given back a bulk of their initial post-election gains.

The U.S. Dollar, which had surged to its highest levels in 8 years, has recently pulled back sharply and now sits at a key level where it was just prior to the election. I think the dollar will resume the uptrend and this offers a good entry point.

The reason for the dollar’s rally was very different than in 2008; back then it was a flight to safety in the wake of the financial crisis, this time it was on the belief the Federal Reserve would embark on accelerated interest rate hikes and Trump’s protectionist policies would cause upward pressure. But suddenly, it’s not panning out that way and there were three major drivers of the dollar’s reversal.

First and probably most important was that the dollar had become a crowded trade, with pretty much everyone believing it would carry on up. Bets on dollar futures had rarely been higher, and the consensus in favor of the dollar was strong.

Underlying this positive sentiment were two fundamental arguments, neither of which has so far worked out: Central bank divergence; and U.S. tax policy.

The Fed’s December hike marked the resumption of its interrupted rate cycle, while the central banks of Europe and Japan were stuck with hopeless economies and no inflation, and so wouldn’t raise interest rates in the foreseeable future. But signs of inflation and faster growth have shifted the European Central Bank out of easing mode and talk of a European “taper” has begun. In their March meeting the Fed tamped down expectations for 3 to 4 more hikes in 2017 to just 1-2 more this year. Bond yields have moved back down to pre-election levels, causing some selling in the dollar.

The second reason investors were so bullish on the dollar is the initial odds had been the Republican-controlled House proposal for a border tax adjustment would restrict imports while helping exports, giving a boost to the dollar. This notion no longer seems like it will come to pass.

But I think just as the initial dollar bull assumptions went too far, so have the recent bearish outlooks. Mainly, I think the Fed will once again have misread the economy. For years they overestimated growth, predicting GDP would come in 2%-3% while the reality was 1.5% growth.

Now, despite signs of an economic pickup, and yes some help from fiscal stimulus such as infrastructure spending, the Fed has lowered their forecast to 1.5%- 2%, citing the possibility of secular stagnation; can you say recency bias?

If economic data and earnings continue to trend higher the Fed will be forced to move and dollars’ rally will resume.

I’m using the exchange traded fund Powershares U.S Dollar Fund (UUP) as a vehicle for establishing a bullish position.

I’m targeting the purchase of the September 26 calls for a mere $0.40 a contract to leverage up the trade.

— Steve Smith

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About the Author: Steve Smith