The dollar has turned

The dollar has turned

I rarely read about someone in the MSM who embraces the notion that we humans do not base our decisions on rationality, but on emotion.  Of course, this destroys in one fell swoop the basis on which economic theory as taught in universities! The latter is based on the notion that we always make economic decisions based on rational maximum utility – we will always and forever choose that option that gives us the greatest return (or the smallest loss).

But in recent times, an alternative idea has gained ground, albeit very slowly, which is called behavioral economics – and the latest Economics Nobel Prize awarded to Richard Thaler goes some way to recognising that our emotions play a significant part in decision making.

Some time ago, I mentioned the work of Daniel Kahnemann in his book Thinking Fast and Slow (I still recommend it) that suggests our brains have two speeds and it is the ever-changing interplay between them that drives our emotions and hence our decision-making process.

Long time readers of mine will already know that I wholeheartedly subscribe to the notion that markets are moved up and down by changes in sentiment – that is, how participants feel about the future.  It is not about what the data project because all data (even if accurate, which it is usually rarely the case), is subject to human interpretation – and this is subject to in-built bias.  Another huge question is: which data do I consider relevant? Economics is most definitely not a hard science – such as physics – that has universal rules.

If you want to understand human nature, you could do worse than study history, especially the Ancient Greeks and Romans, who thankfully, left us with much of their writings.  One of the most prominent historians on TV these days is Bettany Hughes, who specialises in that period.    “A number of politicians have failed to recognise the consistent truth of history: that we’re both an emotional and a rational species, and that we make decisions very emotionally,” she says.  And that goes for investors. too!

How about that?  Investors who fail to understand this will be buying at the tops and selling at the bottoms.  That is where emotions are running high – often at extremes where herding is greatest.  I have shown countless examples here of markets making major turns when sentiment is high, but falling.

This effect of new highs in a bull market unmatched by momentum measures (a measure of sentiment) is one of the most powerful weapons in my Tramline method.  I am always looking out for momentum divergences following an extended run..

For much of the year, sentiment towards the dollar has been negative. Those that like to find rational ‘reasons’ for this bearish mood point to the Federal Reserve’s policy of keeping short-term interest rates low.  Because the euro makes up the bulk of the currency basket against the dollar, we should expect its rise this year to be based on a larger yield spread with the dollar.  But that is not the case – we have continued QE in the EZ and many sovereign bond yields are negative (see previous post).  And even junk euro corporate bond yields are now lower than that of the ‘risk-free’ 10-yr Treasury!

Surely, if fundamentals make the markets, we should have seen a rising dollar this year.  So what is the answer?  There isn’t one under the ‘data makes the markets’ theory.  But there is one if you consider the majority of market participants are taking a highly bearish view of the picture.

Some are saying the dollar is losing its reserve currency status in favour of the Chinese yuan and certainly the dollar has lost ground against it this year.  But the dollar has had this status for a century almost and is still the currency of choice when the local currency is un-trusted.  Think Central and South America, Africa, much of South-East Asia and the dollar is the most-wanted.

For much of the year, I have been following the dollar’s decline which has been accompanied by a large increase in bets by money managers (trend-followers) against it.  Here is a plot of the COT data of money managers (MM) against the dollar index

chart courtesy

At the start of the year, the dollar was rising and MMs were piling into bets against the other major currencies.  But as they rose in value (dollar sliding), they were slow to reduce their exposure and then generally followed the market down by accumulating long currency bets (short dollar).  This one chart shows that the market is driven by sentiment. Sentiment down, market down.  Sentiment up, market up).

In early September, when the dollar made a low of 90.80, the MMs were still piling into short dollar bets as they believed the trend would continue down.  Why would they think otherwise?  They were correct for many months and were basking in the glow of being proven right.

But a funny thing happened last month – the dollar started rising.  And a mammoth short squeeze got under way.  If, like classical historians, you go back into market history, you will see this effect repeated time after time.  In fact, for a bull market to start after a long bear trend, we must have most speculative traders on the wrong side of the market (the ‘smart-money’  trade, naturally, are on the other side).  Otherwise, the market would resume its downtrend as more money piled into the short side.

At major market lows, the trade becomes crowded and the well of new bears is empty compared with the normal run of profit-takers. But no bell is rung at the bottom – and no data point could possibly emerge that could turn the bears into bulls in an instant.

To put today’s market in perspective, it pays to go to the long-range chart.  Here is the monthyl back to 2002

The movement this year has not been unusual but at the current level, MMs are extremely bearish on the dollar.  In fact, the decline is a minor retracement of the bull market that has been in place since the C wave low of 2008! (bull market = higher highs and higher lows).  Note the form of the advance – a long and strong wave 3, a move in wave 5 to the Fibonacci 62% resistance (normal) on a bearish strong momentum divergence and a decline to the previous purple wave 4 low (a normal target).

My best guess is the September low is either wave 2 or wave B – either way, a significant advance is likely.  Here is a close up of this year’s decline

I have a textbook reversal setup.  The decline is an A-B-C correction to the main uptrend with wave C a clear five down on a momentum divergence.  Not only that, but the wedge (or ending diagonal) trading channel has now been broken, which sets up the major target at the start  of the wedge around the B wave high at 102 area.

So how are the waves up off the low conforming to this forecast?  Their form is a potential small five up that will, when confirmed by a move above the wave 3 high at 94, set in the first wave of a large five up.  I am able to suggest this because wave patterns are self-similar at all degrees of trend.

Note that I am not trying to rationalise this more bullish dollar behaviour by reference to the data or news story.  When the advance is well under way, I am sure the MSM usual suspects will be doing just that.  For anyone trading on the data, will they understand what is happening?  Maybe not, since the MMs are selling into the rally!

The euro trades in a similar way but in the opposite direction.  Here is the EUR/USD

The Elliott wave shapes are similar but instead of a wedge, I can set tramlines on the rally.  And I have a clear five up to the 121 high when I started looking for a short entry to anticipate the decline.

With the lower tramline broken (bearish), I can now see a potential Head & Shoulders reversal pattern with a clear neckline at the 1.17 area.  Breaking hard below that would confirm the reversal – and cement a small scale five down to boot.  My first target then is the 1.12 – 1.13 area.

Naturally, I advised VIP Traders Club members to short this market at 1.20 on 18 September and I will be adding to positions if my forecasts pan out.

One related market is the T-Bond and yields there are rising quickly (against the consensus) and we are also short looking for a large third wave up in yields (down in price).

The run-up to the New Year promises to be extremely eventful – and profitable!  I am watching the Dow/S&P like a hawk as it is in its final explosive up phase before The Top which I expect in the next few days/weeks.

For details on how you can get  your two-week Free Trial membership to my VIP Traders Club, click here.


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