August Marks Major Inflection Point for Markets?

By Lance Lewis  AUG 17, 2009 10:15 AM

Evidence strongly suggests that the dollar's rally won't last forever.


We got confirmation of sorts late on Friday per the COT report that the sharp dollar rally beginning during the first week in August was indeed, apparently mostly short covering ahead of the FOMC. And I have no doubt we’re getting more of it this morning, as well.

As of last Tuesday (the day before Wednesday's FOMC), the COT report revealed late on Friday that specs had broadly cut their net short positions in the dollar by just over a third during the recent 3-day rally that had occurred off the dollar index’s low for the year on August 5. In all likelihood, that short position has been even further reduced since then.

Now, obviously the OTC currency market is much bigger than the futures market -- which is where this COT report comes from -- but more than likely, the futures are fairly representative of the OTC market as well.

As a result, it’s another reason to believe that the recent bounce in the dollar is going to fail, just as the relative strength in gold and commodity prices during the dollar's recent rally had been telling us -- even before we got this datapoint.

Speaking of which, note that even as the US dollar Index has traded back up to its July 29 high, just shy of the 80 level this morning, based on the usual knee-jerk “sell equities = buy dollars trade” gold, silver, crude oil, and the CCI equal-weighted commodity index are nowhere near their lows of July 29.

Given the large number of dollar bulls/dollar deflationists that have already come out of the woodwork in the last 2 weeks to embrace the dollar’s rally off its low as the beginning of some sort of repeat of 2008's dollar squeeze, a renewed sell-off in the US peso (and the likely corresponding rally in gold) could be rather violent, too. Basically, it seems to me that we could be at a major inflection point, and it’s ironic since we’ve also had major infection points occur around this July/August period in both 2007 and 2008, too, when you think about it. What is it about August?

Now, obviously inflection points are never really knowable except in hindsight, and I don’t claim to have a crystal ball. But I tend to think we may be about to see a big shift in some of the trends that have prevailed for most of 2009.

Chief among those trends has been the tendency for the S&Ps to rally every time the dollar has weakened and vice versa, with many concluding that a weak dollar means investors are taking on more “risk," and vice versa.

If the dollar reverses and its recent bounce continues lower this week, I believe it’s likely to accelerate dramatically to the downside -- and probably take the bond market with it, to some degree. And that’s probably all the excuse that the equity market needs in order to finally trigger a correction of sorts (even though it may only be a shallow one given all the liquidity that's sloshing around out there and the fact that credit spreads have yet to blow out to any degree). On the other hand, gold and many commodities (as well as their equities) should rally under that set of circumstances given the weakness in the dollar.

I also think we’re seeing the early signs of a shift in general sentiment too in that dollar weakness will likely begin to be perceived for what it actually is rather than a so-called “economic recovery trade” or “flight to risk” (which ironically implies that the dollar is somehow “safe,” even though it has lost over 90% of its purchasing power since the Fed came into existence).

In reality, what the dollar’s weakness since March really represents is a move by capital to the parts of the world that have savings and are already showing signs of sustainable economic recovery and away from the US economy, where there's economic stagnation, enormous amounts of debt, and rising inflationary pressures (i.e., stagflation).

Let’s look at the recent second-quarter GDP data for example. China, Japan, Germany, and France all reported positive GDP in the second quarter, while the US continued to see GDP contract. How much more obvious does it get? A falling dollar is not a “flight to risk,” it's capital “flight from risk,” and that risk is the highly distorted, asset price appreciation-dependent US economy that's heavily in debt, both publicly and privately. The “safe,” greener pastures are elsewhere in the world. After all, capital goes where it's treated best.
Position in gold and gold stocks

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