Questioning My Dollar Premise

Each weekend, I will take a look at the various indicators I follow from the many different financial markets and ask, "what is the market telling me?" Over the past month, with this massive dollar bounce, biggest in several year, I have been under the assumption that the selling had dried up and a low had been put in. In fact, there was a double bottom of sorts on the charts, which in my world, is bullish. However, as I was reviewing some things this weekend, I left with a quandary of sorts. That quandary involves three variables: The Dollar, Gold and the 2 year note.

Now each of these has been on the move for one reason or another during 2008. If you look at the charts, the dollar and the 2 year seemed to have bottomed around the same time. Gold simultaneously topped within the same time frame. The moves of these three securities held in place till last month when the 2 year note reversed course from the 2.75% level. Meanwhile, gold and the dollar have continued their negative correlative moves. From a macro point of view, I believed the move in the dollar was based on overnight policy - essentially that the ECB and BOE were way too tight with policy and their next move was down, while the Fed was too easy with policy and would have to tighten next. This is a sound argument generally for any currency pair. However, the move in the 2 year has me rethinking this premise.

Why? Well, if the market is indicating that lower overnight policy is coming, then the dollar trade, based on overnight rates, is no better than the UK or the EU's. In fact, their overnight rates are higher on a fair value basis. Generally, when all three are moving in the same direction, the one with the highest fair value combined with rising growth, has the most strength. Currently, the one with the strongest growth is the US but the highest fair value belongs to the ECB. If the US is now expected to possibly keep policy steady for sometime, the Euro might actually draw support. That assumes though that the premise, of overnight policy, is the guiding light for the dollar. I am starting to believe that it might not be. Here is a list of other things also occurring in this environment.

• The spread in the 2 year note price and libor 1 month futures is tightening. This generally argues for a fall in risk within the financial system. As the chart shows, libor has stabilzed.
  
• The NDX 100 is leading the S&P 500 from a momentum standpoint. When such is occurring, in a rising time frame, generally speaking the growth in the local economy is picking up.
• The Bank Index (BKX) has been the crux of the financial market problems over the past year and still remains substantially below its August levels. If all were great in the world and risk was leaving the system, these banks would be rallying back more aggressively.
• The Philly Homebuilder Index (HGX) has staged its most impressive reversal in several years to the upside.
• The CRB downtrend looks like it has legs on the long term chart down towards the 350 level or another 8%.
• Falling copper prices has in the past been a good leading indicator for growth. The price has been pretty much range bound since the beginning of 2006 so growth globally probably leveled out at that point. Right now it looks like it is heading lower towards the 300 level or another 8%.

So there are the variables. What stocks out the most to me? Well, the British Pound had a very high correlation with its housing market throughout this decade. When its market began to have troubles, right after the latest hiking campaign by the BOE, the pound began to crumble from 210. As the problems have worsened, so has the pound.

Interestingly, the US's major problem has been the credit markets and what housing has done to those credit markets. Many analysts have said, once the housing market stabilizes, the credit markets will stabilize. Using the libor vs 2 year note read, the two are coming together and the standard deviation of libor seems to have fallen arguing for abating risks. The homebuilders are in major rally mode and it looks like it has legs for another 20%. Rising trends in the homebuilders do not occur generally against weak real estate markets.

So there perhaps sits the support point for the moves. Risk is abating in the housing market and the homebuilders are moving up. What appears to have driven the dollar down over the past year has been risk to the system. The move in gold shows that the capital flight from the US is over. The move in the 2year and treasury curve along with the collapse in the cRB appears to signal that inflation is abating. Lower inflation and stabilizing credit...at this point has translated into a higher dollar. Sustainable? No. But for the short term, should continue to move the dollar higher.