Is the US Dollar wrecking ball back?

At the beginning of February, I laid out my investment outlook for this year.

I was positive risk assets for several reasons.

One of these was my expectation that the US Dollar would trend lower, I wrote: “Why will risk assets go higher? Three reasons. The first one is because the USD will go lower.”

This is sort of what we’ve seen this year. Equity markets have been trending higher but the US Dollar didn’t really decline.

However, the US Dollar failed each time it tried to develop a sustainable rally.

Again in early April, I wrote that it looked like the dollar would go down again: “What could drive this new leg higher in risk assets? As I’ve written before, the US Dollar plays a big part in this. Last week, it failed for the third time to get overbought. Although there are medium-term reasons to be bullish the USD, price action still hasn’t confirmed it.

Therefore, I’m agnostic about the medium-term direction of the US Dollar, and it can thus be the fuel that drives the next leg higher in risk assets.”

That proved to be the top of the Dollar.

Things seem to be changing however.

Note on the following chart how the bottoming formation in the US Dollar in August and December last year was very similar. Price continued to set lower lows, while the RSI showed a positive divergence by setting higher lows. The low in the US Dollar was in when the RSI failed to get oversold on a new low in the US Dollar price.

Once these rallies developed, notice how the RSI never got overbought. This was the technical signal on the US Dollar that I was watching closely. As long as the RSI didn’t get overbought, thus signaling a lack of strength in the price movement, there was nothing to worry about.

With this latest rally however, RSI got overbought for the first time in a long time. Also notice how the RSI never got oversold during this latest decline in the US Dollar.

In my opinion, this is a clear shift in the behavior of the US Dollar.

Is this really that significant that the RSI got overbought? Most people see an overbought RSI as a signal for prices to go lower again. However, a lot of times, an overbought RSI signals strength in the market and prices continue to go higher.

The following chart shows that each time the RSI of the US Dollar got overbought during the last 7 years, the US Dollar got stronger, not weaker.

The rising US Dollar has already had a big impact on several markets.

I’ve been warning about copper for several weeks:

-When gold and emerging markets reached their all-time highs, they corrected for multiple months. My expectation was that the same would happen with copper. (see this link for chart)

-Copper was retesting it’s breakout level and I wrote that it better held those levels or copper would be in trouble. (see this link for chart)

This week, copper failed to hold on to its breakout level on a weekly timeframe.

Another thing I noticed was that Bitcoins’ price action was clearly changing. Since I warned about it, prices have corrected significantly.

In my tweet above on bitcoin you can see that I wrote that the price action in several assets was supporting ‘something’.

The thing I was writing about was a possible trend change from risk on to risk off.

We started to see it in the price action of certain asset classes but it is also supported by the fundamentals.

As the following chart shows, a strong economy (in rate of change terms, as represented by the ISM here) is usually not good for the stock market.

The vertical black lines show when the ISM gets above the 60 level. As you can see, stocks usually see a correction or long consolidation not much later (indicated by red circles).

Has the time come that the weakness we are seeing in things like copper and bitcoin will start to spill over to the broader equity market?

It’s certainly interesting to note that the S&P500 has reached its price target. (Fibonacci extensions work rather good to set price targets once prices get into new all-time highs, and there are thus no more resistance levels.)

As you can see, we are now slightly above the 1,618 Fibonacci extension of the Corona crash.

Notice that the Corona crash itself started at the 1,618 Fibonacci extension level of the Q4 2018 market decline.

Also notice how the equity weakness in 2015 and 2016 started at the 1,618 Fibonacci extension of the 2008 market crash.

The combination of all these factors (rising US Dollar, strong economy is not good for the market, price target reached, other asset classes starting to show ‘bad’ behavior) makes me think that the stock market could be in for some trouble. (Trouble = 10% correction or a long consolidation.) (I’ll explain later in this article when this view would be wrong.)

This is something I was already anticipating in early February when I wrote: “Imagine we are April/May/June 2021 (I don’t know the specific point in time) and the S&P500 is 10-15% higher and interest rates have reached their target.

At this moment, bullish sentiment and positioning will be extreme. Everything will be priced into the equity market.

The higher interest rates will start to put pressure on the US economy and the US equity market will start to discount this."

Let’s get to gold.

I laid out the fundamental backdrop that I was anticipating for much higher gold prices in early February when I wrote: “The markets will correct and the Fed will need to step in. The Fed will see that higher interest rates are sending the US economy back into recession when unemployment is still extremely high and the economy extremely weak (on an absolute basis). This is the moment when the Fed will need to introduce Yield Curve Control. This is also the moment that gold will start to rise again in a significant way.”

Note that at that moment, I was bearish gold because interest rates just broke out.

Gold prices declined and started to bottom in March-April. I got back in the gold market at the end of April - early May.

Gold got crushed this week for two reasons. The first is the rising US Dollar. The second is the fact that the Federal Reserve was more hawkish during its meeting this week than the market was expecting. Both a rising US Dollar and rising real interest rates crushed gold.

Let’s take a closer look at the US Dollar. I’ve written in the past why I’m long term bearish on the US Dollar. If you look at the following model, you can see why I think that we’ll enter a multi-year downtrend in the US Dollar.

(Valuations also support a decline in the US Dollar.)

How do we reconcile this big picture bearish view on the US Dollar with my earlier observation that once the RSI of the US Dollar gets overbought, it usually continues to get stronger?

As I’ve written in the past, it’s important to analyze the data differently depending on the market regime you are in. (For example, high speculative positioning in gold works well to capture peaks in a long term bear market but not when you are in a bull market.)

So, let’s have a look at the usefulness of the RSI signal in the period from 2000 to 2009, when the US Dollar was in a long-term bear market.

As the following chart shows, when you are in a long-term bear market, an overbought signal usually marks the top.

So, are we already in a long-term bear market? My model certainly indicates that we will be in one for the next few years. But if you look at the technical picture, it is not yet confirmed by the market in my opinion.

If you look at the weekly chart, it’s only when the 89 level gets broken, that we can be certain that the multi-year bear market has started.

Don’t get me wrong, I think this level will fail sometime in the future (because my model indicates it). But, we could be witnessing the start of the last dollar rally before the multi-year downtrend starts.

As the following chart shows, medium-term US Dollar strength wouldn’t be surprising given the fundamentals strength of the US economy versus the rest of the world.

Source: Martin Enlund, Andreas Steno Larsen, FX weekly: a 20% stronger USD on the cards?

The way the US Dollar behaves in the next few days will tell us a lot. If it continues to rise, we know we are in for more strength. If it starts to fall quickly (as was the case during the 2000-2009 bear market), we know that the bear market has already started and that the 89 level will probably fail in the near future.

This price action will also tell us if we should indeed get worried about risk assets or not in the short term.

Normally I would now go on and write a fundamental analysis on gold, real interest rates and the Federal Reserve. But since my views are not clear enough at the moment, I’ll skip that.

For me, only the technicals matter now.

As the following chart shows, gold is now at a crucial point. In my opinion, this is a must hold level. Gold broke down in March this year but was able to recapture this level in April, thus making it a failed breakdown. We now saw an extremely hard retest and in my opinion, it’s a must hold level.

The relative strength of silver has been very impressive during this multi month correction in the precious metals sector. As you can see, gold made several lower lows (indicated by the red line) while silver made higher lows.

If you look at the topping formation in 2011-2012, we saw the opposite. After its peak and first correction in 2011, gold had three rallies that all stopped around the same price level (red line).

Silver however made three lower highs.

It is clear that during the 2011-2012 topping process, silver was behaving much weaker.

This time, silver is behaving much stronger than gold. This indicates to me that big picture the bull market is still intact and well.

The short-term picture however, doesn’t look as good. The price action in some mining charts is just awful. The whole sector was looking very bullish but it all changed this week. I showed this big picture view of the current price action in gold versus silver, now versus the 2011-2012 top, to remind myself that if gold will structurally go lower, silver would probably not be behaving as well as it is doing right now.

Gold will need to prove itself very quickly and the US Dollar better fails or gold will have a rough time doing it…

We are at a crucial point for the US Dollar and gold. Let’s see what next week brings.

Thank you for reading my article.

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