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How the Dollar Index Got Set Up for a Violent Reversal


Next week's FOMC meeting could be the trigger.

Many people seem to mistakenly believe that the dollar index is the dollar. It's not. The dollar index (or "Dixie" as some lovingly call it) is an index just like the Dow or S&P, and it's heavily euro weighted. But also like the Dow or S&P, a move in this index based on the gyrations of one component that has a big influence isn't to be trusted any more than a big rally in the Dow because of a meltup to a new high in, say, IBM.

Just like a move to a new high in the equity market based on extremely bad breadth, a rally in the dollar index based on the motion in one currency is set up for an accident. And that's exactly what we saw occur this week.

As I noted on Wednesday in the Buzz & Banter, the rally in the dollar index to a new high for the move above its December high that dollar bulls were dizzy with excitement about came on the breadth of one major foreign currency taking out its December low versus the dollar, and that was the euro.

Since then, the euro has stabilized and reversed back to the upside, and the other foreign currencies have turned back up as well, with the yen even trading up to a new high for the year. Gold and silver have also both managed to stabilize above their December lows despite the dollar index taking a peek above its December highs. That's a positive divergence, and it's talking to those who are listening.

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Click to enlarge

Now throw in the fact that the Gold Forward Offered Rate (GOFO) has collapsed to levels not seen since the ultra-tight conditions in the physical market back in November 2008, which saw the gold market actually move into backwardation briefly and set up a rally of more than 30% over the next three months.

Let's look at some sentiment data too. Consider that the Rydex gold fund (which is a fund of gold equities) saw a whopping 40% of its assets exit the fund in a panic yesterday, which is a one-day record.

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Now, consider that like the December shift by specs into a large net long position in the dollar and the fact that the PowerShares DB US Dollar Index Bullish (UUP), the dollar index ETF, continues to regularly run out of shares, a recent Morgan Stanley survey of hedge fund managers reveals that the dollar is currently the favorite "long."

What does that tell you about the most crowded trade on the planet? And yes, that "crowded trade" is and always has been "long the US dollar". After all, how can it not be given that the dollar is the former sole reserve currency of the world's monetary system?

Put it all together, and we have the setup for a sudden and violent reversal in the dollar index and a meltup in gold and gold stocks some time over the next few days in my book.

What could trigger something like that? My guess is the catalyst is likely to be the FOMC announcing at next week's meeting that it will be expanding and extending its MBS monetization program beyond the current planned March end date, but it could be anything.

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