Dollar Fires Shake up the Market (DXY, XLI, XLK)

We’re going to start today with some comments on the dollar. Why? Because going into the weekend the dollar is looking stronger than it has in over a year.

As the chart below shows, the U.S. Dollar Index (DXY), a widely accepted theoretical value assigned to buck, that’s calculated as a composite of a basket of six foreign currencies, has not seen a sustained move above all its moving averages since July of last year.

Take a look –

dxy731
After wallowing in Nowheresville for a full annum, the buck sprang to life last month, pushing north of all its moving averages before bucking up against overhead pressure at DXY 81.5 just yesterday (green line).

A look at the latest RSI readings, however, tells us that the move is likely over for the time being, as we’ve nearly reached the strongly overbought RSI 80 level, the height at which most securities stall out and encounter a bout of selling, or, at the very least, a period of sideways drift before regrouping.

Our own estimation is that we’ll presently see a decline back to current support (former resistance) at the long term (411-day) moving average at roughly 81 (yellow line).

We should add that with a clear double bottom in place at DXY 79 (in black) and the rest of the MAs starting to turn higher, we’re less concerned about a deeper dip lower for the Dollar Index at this time.

giddy

The Meaning of a Strong Dollar

It’s for several reasons that we highlight the beginnings of what we believe is a dollar breakout.

First of all, a strong dollar means U.S. denominated assets become attractive to global investors. Everything from real estate to stocks to domestically oriented businesses and derivative assets are more likely to grow in value. Speculative initiatives and carry trades are also opened that further enhance the strength of the dollar against foreign currencies in a self feeding loop that has the potential to make for tremendous volatility in the currency pits.

Second, a stronger dollar is also a potential net negative for commodities that are traded exclusively in the greenback. We highlight the dangers particularly to precious metals and crude oil investors only because we have a great many readers with an interest in those two items, but the impact of a stronger dollar would certainly be felt across the full range of the commodity spectrum. A full 80% of all international transactions are executed using the dollar.

Third, a stronger dollar is anti-inflationary; a relationship that we believe the Fed would be more than happy to face at this point. Why? With the deflation boogeyman slowly melting and the global expansion gaining traction, rate hikes loom ever closer, and it serves the Fed’s interest to let market forces assume more responsibility for the direction of rates, all the more so if inflation is held in check by a more muscular buck.

Have a look at the charts below for a graphic idea of how the relationship works –

inverse

This is three years worth of data for the two series, one plotted above the other. And while the relationship is not a strict ‘one-to-one’, movements between the two are very clearly inverse. When the dollar is rising, the CPI loses ground, and vice-versa.

Temptations and Warnings

The dollar’s rise will not be an overnight affair, but it will have certain, distinct financial repercussions, a few of which we’ve outlined above.

It will also shake up the current trend set in ways that we can’t predict.

Our suggestion for today, therefore, is to take the two sectors of the market that are currently trending at opposite extremes and play them against one another – the powerful sector to retreat and the weak to regain lost ground. Because once a clear understanding takes hold that a dollar surge is underway, money will begin to be redeployed in any manner of new directions. And that shakeup should close the gap between the two, above mentioned variant equity sectors.

And what are they?

We see a tremendous variance today in the performance of the tech and industrial sectors, the comparative chart of which looks like this –

xlkxli

 

Six-months worth of data shows that the two walked hand in hand until the last week in June, at which point the industrials sold off and the techs kept rising.

There was no reason for this that we could figure.

So we’re going contrarian.

A simple long Select Sector SPDR Industrial ETF (NYSE:XLI) and short Select Sector SPDR Technology ETF (NYSE:XLK) trade would cost you roughly $1315 per board lot traded.

And you’d profit as the gap closed.

Many happy returns,

Matt McAbby, Senior Analyst, Normandy Research

See what people are saying...

  1. Gary Haas

    Well you were right about CP. I didn’t want to get out, but thought better after a few days, and beat the drop.

  2. Tom M

    I was impressed with the XLK XLI thoughts. When I put the numbers in the XLK closed
    at $39.00 and the XLI is at $51.83. So am I missing something?

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