Michael Gayed: Why the Dollar Could Drop Hard if Correction Is Here
The dollar is often perceived as a "risk-off" trade, but there's a real reason why it could fall hard if the correction is here.
Intermarket trends across the board are acting far more normal following 2013's outlier environment as cause-and-effect makes a comeback. We appear now to be in a classic risk-off period, defined by a deflation pulse that is causing worldwide risk assets to fall, increased volatility, and higher internal correlations. During such periods, certain areas tend to benefit, most notably the VIX (INDEXCBOE:VIX), gold, the yen relative to the dollar, the dollar relative to everything else, and Treasuries.
The yen part of the opportunity set is clearly strengthening as the carry trade unwinds. However, the dollar relative to everything else really isn't rising that much. Shouldn't the greenback be considered a safe-haven play given how sharply stocks have fallen in the past three weeks? Take a look below at the PowerShares DB US Dollar Index Bullish Fund (NYSEARCA:UUP) and note that the ETF has barely appreciated since the risk-off period began.
So what gives? First, consider that deflationary pressures remain high in the US, but higher in Europe. Because the euro makes up 57.6% of this fund, its movement will largely be defined by how the euro itself is acting. Deflation bets tend to benefit currencies on the upside, which means the euro has underlying upward pressure relative to the dollar.
Aside from the euro though, there is a fundamental reason why the dollar may fall more broadly. The US stock markets has been seen as a bastion of strength among world equities, especially as foreign direct investment increased and money from overseas invested in our shares. If we are in the midst of a resync, and if stocks are responding to the reality of failed reflation, then that same money could rush back out on a risk-off juncture, causing the dollar to undergo selling pressure as a result.
It should be an interesting period ahead, but if the dollar is now removed from the opportunity set of risk-off plays, it may only accentuate movement in everything else. My firm's ATAC (Accelerated Time And Capital) models used for managing our mutual fund and separate accounts continue to favor long-duration bonds here until internals improve.
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