There’s never a shortage of distractions in our 24/7 news cycle and social media-addicted world. It’s more and more difficult for investors to discern the critical market developments from noise, says Landon Whaley of Whaley Global Research writing in his Gravitational Edge.
While everyone has been preoccupied with the latest Trump tweetstorms and central banker soundbites, there’s been a critical development getting absolutely no airtime.
Since the beginning of January, the greenback has quietly been the best-performing currency in the world, gaining almost 200 basis points. It’s no secret that during last year the dollar was as hated as Harvey Weinstein, thanks to its movement in a virtual straight line down since January 2017.
To be clear, this is not my call for an end to the bear market in the world’s reserve currency. However, I’m calling for the USD to move higher for several more weeks, and letting you know now that the implications of this dead cat bounce, however short-lived, could be immense.
Fundamental Gravity says what?
Every asset class has two masters: economic conditions and central bank policy. However, these two variables don’t exert equal force on the risk and return of asset classes.
Rather, they dance a waltz in which sometimes economic conditions lead, and at other times central bank policy is in charge.
When these two variables are aligned for an asset class, either bullishly or bearishly, then it doesn’t matter who’s leading: their direction is clear. However, when conditions and policy simultaneously indicate two different performance profiles, the question of who’s the lead and who’s the follow becomes critical.
This is the exact Fundamental Gravity situation we’ve had for the U.S. dollar for the last 14 months.
When U.S. growth is accelerating, as it is now, it’s historically dollar bullish. During growth-accelerating environments, the USD has averaged a +2.9% gain, while experiencing an average drawdown of −8.7%. In contrast, when U.S. growth is slowing, the USD has averaged a −5.8% decline and an average drawdown of −16.7%.
However, since this latest growth-accelerating regime began in July 2016, the opposite happened: the USD has declined −4.6% and experienced a maximum drawdown greater than −13%.
What gives here? Is the model broken? Nope.
What’s happening is that economic conditions aren’t leading the Fundamental Gravity dance right now. Instead, Fed policy is pushing the greenback around the floor.
When the Fed hikes rates, the dollar’s performance is as miserable as Uncle Paul’s karaoke rendition of “Achy Breaky Heart” after his fourth bourbon.
In the six months immediately following a Fed rate hike, the USD behaves in a predictable manner. Since the Fed’s first rate hike in a decade in December 2015, as well as the three following hikes, the USD has averaged a −4.7% decline, while experiencing an average drawdown of −7.6%.
Likewise, in the two and a half months since the latest rate hike on December 13, 2017, the USD has declined −2.8%, experiencing a maximum drawdown of −5.2%.
Being data dependent cuts through the crap because the slope of data doesn’t lie; narratives do. Powell’s apparent laser focus on normalization, and the Fed policy’s firm control of the USD’s performance, means that the bear market still has legs for days.
That said, markets don’t go straight up or straight down; rather, they move in waves. Since hitting a short-term bottom on February 26, the USD has found its footing, and although I believe it will be a blip, I see signs that there’s more upside to come.
Quantitative Gravity says what?
As a reminder, the Quantitative Gravity component of our Gravitational Framework is not technical analysis, which is both ineffective and misleading. Rather, we use quantitative measures that are based on the reality that financial markets are a nonlinear, chaotic system.
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Most investors are hyper-focused on price action. Unfortunately, price is nothing more than the current point where there are equal parts of disagreement on value and agreement on price. Crucially, price is the last aspect of a financial market to move, quantitatively speaking.
We’ve identified four primary quantitative dimensions of financial markets that affect price movement: energy (trend), force (momentum), rate of force (buying pressure), and a market’s irregularity.
To analyze the first dimension—the energy (trend) of a market—we use a measure called Social. This measure helps us identify when the market is in one of four states: party (bullish), hangover (bearish), taking a breather or completely asleep. After spending the first six weeks of 2018 in hangover mode, the USD slept for several weeks and is now waking up. The price move that comes after a slumber is typically a large one.
The other dimensions are signaling that it’s likely the USD is waking up into party mode.
To analyze the second dimension, we use a measure called Momo, which helps us understand the amount of force (momentum) behind the current state of the market, which we identified using Social. Momo has been building bullishly since January 31 (three weeks before the price bottomed) and is now positive for the first time since mid-November. Anything that happens for the first time in four months in a market as crucial as the U.S. dollar demands attention.
To analyze the third dimension—the rate of force (buying/selling pressure)—we use a measure called Barometric. This measure gives us immensely more information about investors’ degree of conviction than a simple measure of volume alone. Barometric bottomed on January 26 (four weeks before the price bottomed) and has been showing building bullish buying pressure ever since.
To analyze the fourth dimension—the irregularity of the market—we use a measure called Volatility. This measure has been declining since it peaked on January 25 (four weeks before the price bottomed).
When a market’s Quantitative Gravity is characterized by falling Volatility alongside a rise in Momo and Barometric, it typically precedes a multi-week rally in price.
A climb in the dollar after a 12-month downtrend is not just important for those who are involved in that market. Because of the dollar’s tentacles and connections to just about every other market on Earth, the implications of this rally are widespread.
To assess these implications, we monitor another quantitative aspect of markets: the relationship between asset classes.
When I evaluate the relationship between various markets (S&P, crude oil, broad commodities, gold) and the dollar, for 15-day returns all the way out to 180 days, all I see are strongly inverse correlations.
The bottom line is that if the dollar goes up, a lot of other markets go down.
Behavioral Gravity says what?
Our Behavioral Gravity lets us check how investors are perceiving this situation. In short, these folks remain as bearish on the USD’s prospects as Yogi and Boo-Boo.
Retail investors yanked $227MM from the PowerShares DB U.S. Dollar Index Bullish ETF (UUP) during 2017, which represented 30% of UUP’s assets! The outflows have continued this year, as investors have pulled another 6% of UUP’s assets in the first eight weeks of 2018.
On the other hand, we have institutional investors who’ve been historically bearish on the USD for over a year. Now, they have begun covering some of their shorts.
The Behavioral Gravity for the dollar is bullish because the overriding bearish sentiment from investors is dramatically increasing the risk of a short squeeze.
The Bottom Line
Fundamentally, the path of least resistance for the greenback is lower as long as the Fed’s current policy remains the same. However, the Quantitative Gravity has recently shifted, and is signaling quite clearly that for the next few weeks, the path of least resistance is higher. Behaviorally, both retail and institutional investors are on the wrong side of this reality.
But it’s not just bearish dollar investors who are on the wrong side of this overdue countertrend rally. The cross-asset relationships we discussed are telling me that March is going to be a difficult month for most of the world’s asset classes and their investors.
You can maintain your composure and focus (while the media and other investors lose theirs) by remembering that the USD rally will be short-lived and will be a great opportunity to take advantage of discounted prices to get long the things you like.
As always, my friends, stay data dependent, process driven and risk conscious.
