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The USD Index appears to be perfectly positioned for significant downside over the coming days. Why? Well in essence the USD is extremely overbought. On the surface it might not seem that way but if you look beneath the surface to the option market something very dramatic has developed as a consequence of the Euro debt crisis!
Since the end 2008 I have been bearish on the USD (being long UDN at about $25). We are up about 17% in that time. However, in light of the wild gyrations in the USD Index during this time I don’t think this is anything to feel proud about. But, that may all be about to change as the stars now appear aligned for material downside in the USD Index to occur right quick! Below is the USD Index, note how precariously close it is to breaking below very significant support.
Now you may think that “technical” analysis is rubbish (I too think that most of the “analysis” coming from “technical” analysts is lunacy to put it politely). However, one cannot deny the fact that every trader and his analyst is watching the USD Index and will have stops at or just below “support” on the USD Index at 73.50 a mere 31 points from where the USD Index is currently trading. Don’t forget that the USD Index has attached to it one of the largest futures markets in the world, accordingly breaks below significant support levels tend to become self full filling prophecies.
The largest component of the USD Index is the Euro. Note how close it is to breaking above “resistance”! I think if we get a close above the 1.45 level then a wave of short covering will occur.
Now here comes the “meat” of my bearish proposition on the USD. I think Euro debt crisis has driven every trader on the planet to buy puts on the Euro so much so that the demand for puts relative to calls is now at a record high! Below is the graph of the one month 25 delta risk reversal on the Euro. Demand is so high for puts relative to calls that option writers have jacked up the implied volatility on puts relative to calls to levels not seen at anytime during the existence of the Euro.
Yes it certainly seems that the crowd is already positioned for something very dramatic to occur in Europe perhaps the crowd is positioned for another “Lehmans” to occur over the coming weeks. Will this happen? Well that is your call but suffice to say this – everyone and everybody knows what happened when Lehmans defaulted. It would be politically unacceptable for central bankers to let this happen again. And that is as much as you need to know.
Of course what happens if banks in Europe are bailed out (assuming they have to be)? Well there is potential for a wave of short covering on the Euro (and by default other currencies) the likes of which we have not seen in many years in the currency market.
A break above 1.45 on the Euro and below 73.50 on the USD Index will have far reaching consequences. Let’s forget what might happen to precious metals and look at the broader commodity group. Note the old CRB Index (the CCI) is also hard up against “resistance”(at the 660 level). It has gone essentially nowhere for some 8 months.
If there is one thing I have learned in my 16 years as a professional trader – the longer a market moves in a sideways direction and the narrower the trading range the greater the intensity of the breakout. Yes we may well be staring down the barrel of significant upside in commodities as well.
Yes it is going to be interesting this week, if we get the Euro closing above 1.45 then I think it is game on to see some very big moves in currencies and commodities. Given the underlying bullish position towards the USD in general, don’t underestimate just how big the moves could be.
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