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US Dollar and Oil Hold Clues About the Future

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The US domestic economy cannot handle significantly higher oil prices from the current levels without seeing business growth slow.

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For the past several weeks the US Dollar Index has pulled back, and the S&P 500 definitely took notice. However, the dollar is on the verge of carving out a weekly swing low that could have legs to much higher prices.

While many pundits routinely mock the dollar and trash it, in the event of a major currency or credit event in Europe, the dollar will be one of the key safe havens that large sums of wealth will migrate to.

If the Dollar Index futures can push through the downtrend line illustrated on the chart above with strong supporting volume a much larger move higher will likely play out. Should that scenario play out, the S&P 500 Index will likely begin to roll over.

It should be noted that the S&P 500 has struggled on multiple occasions to break above the key 2011 highs. The S&P 500 Index daily chart below demonstrates the resistance directly above current price action.

S&P 500 Index Daily Chart



We have been bearish on the S&P 500 since price was testing the 1,330 price level. After the subsequent breakout we targeted the key 2011 highs as a last stand for the bears. If the dollar finds a bottom and rallies sharply higher from current levels a correction in the S&P 500 will likely play out.

The other possibility would be a breakout over current resistance levels which would likely see the S&P 500 move to the 1,400 level if not higher in a matter of a few weeks. We are not leaning in either direction in terms of price action currently, but we are expecting the VIX to move higher in coming weeks and months ahead.

In our most recent collaborative missive, we discussed the fundamental case for gold prices going higher over the long term. Clearly the price action this week (specifically the price action on Wednesday, February 29) has been bearish and we expect to see prices chop around with a potentially bearish view for the next few months.

Gold Futures Daily Chart



While gold has pulled back sharply, the likely move lower in coming weeks and months ahead will offer a strong buying opportunity for investors that are patient. If the dollar breaks out to the upside which we anticipate, gold should move down into a significant low.

Should this scenario play out an entry point near the low will likely offer strong upside potential. In fact, it might be the last deep low before a prolonged period of choppy price action until the dollar tops.

We firmly believe that as long as central banks continue to print money with wreckless abandon, the fundamental case for gold remains quite strong in the longer term.

We have received a lot of emails recently asking about our opinions on the future price action in oil. Even though the dollar may breakout to the upside, oil has a risk premium built into the price already for potential geopolitical conflict. However, military action in the Middle East could easily push prices higher.

Should oil push higher and test the 2011 highs and breakout to the upside, the likely results will be a weakening in the domestic economy as gasoline and diesel prices would surge higher. A surge in oil prices has a direct implication to the domestic US economy as the cost for nearly everything will rise. The daily chart of oil futures is shown below.

Oil Futures Daily Chart



Conclusion
Ultimately my firm and I believe the two most critical assets to monitor at this time are the US dollar and oil futures. The US domestic economy cannot handle significantly higher oil prices from the current levels without seeing business growth slow. Furthermore, if the dollar rallies it could put pressure on the equity markets as well.

While the equity markets and the economy are not the same thing, it is important to note that higher oil prices at a certain point will become equity negative.

The VIX is sending a warning that market participants are too complacent and the dollar is potentially forming a rounded out bottom. These two conditions paired with geopolitical risk in the Middle East represent additional risks to economic growth.

Furthermore, market participants cannot become complacent regarding the potential risk that Europe still poses. With the various risks listed above in mind, we are keeping position sizes small and are attempting to remain delta neutral in our portfolios. Risk is beginning to elevate to extremes.

Editor's Note: JW Jones offers more content at OptionsTradingSignals.com.

For more on options trading, take a 14 day FREE trial to OptionSmith. Get access to veteran options trader Steve Smith's portfolio along with emailed alerts and strategy with every trade he makes. Learn more.

No positions in stocks mentioned.
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