It’s All about the Benjamins

During the last several weeks, the dollar has quietly but meaningfully crept higher. As of this writing, the U.S. Dollar Index has broken above its recent trading range and boosted its 200-day average.

We believe this advance is important because of the dollar’s role in commodity pricing, in corporate earnings and in serving as a harbinger of rate-hike expectations. Generally, a strong dollar is a headwind for commodities and corporate earnings.

Aside from precious metals, which have non-market-correlated qualities to them, commodities in general have stalled out. Just looking at oil, we can see it turning over again and appearing to want to retest the $40 level to provide a 10+% unrealized gain in our short oil ETF, ProShares UltraShort Bloomberg Crude Oil (SCO). Based on the last several quarters of declining corporate earnings, we can see the deleterious effect of a strong U.S. dollar and, moreover, we were just beginning to see the year over year headwinds subside. While it is a bit early to make the call on new highs for the dollar, it is worth keeping an eye on the situation. In addition, it greatly benefits our PowerShares DB US Dollar Bullish ETF (UUP) September $25 calls.

It also is no surprise to us that as the dollar has risen, so have rate-hike expectations. Sure, there is a cause-and-effect relationship between the price of the dollar and interest-rate expectations, but the important thing is that rate-hike expectations are on the rise. Despite the volatility surrounding the U.K. Brexit vote to leave the European Union and the U.S. elections in November, the market is pricing in a 25% chance of a hike in September and a 50% chance in December. Those odds may not seem like much but, at the beginning of the month, they stood at 2% and 12%, respectively. Should this rate-hike chatter gain steam, we surely will see treasuries sell off and rates move higher in a dramatic way to benefit our iShares 20+ Year Treasury Bond (TLT) August $138 put position.

While the dollar’s strength plays a role in corporate earnings, which affect the equity market, the dollar’s value does not have a direct impact on stocks in general. What concerns us most about the equity markets is the almost 9% uninterrupted move higher since the Brexit low. Suffice to say, we do not think this advance in equities will end well. Now, we don’t believe we are going to enter a period of prolonged weakness, but markets with extended gains and substantial drops historically have been met with deep corrections. We are reminded of the old saying that the market takes the steps on the way up but takes the elevator down.

With respect to our positions, we have seen a big improvement in our long-volatility trades in commodities and bonds. While our short-volatility trades are continuing to decay, they are challenged a bit and we will continue to monitor them to determine the best course of action. We do have some time on our side and the elevator down looms large, so all in all we are happy with how we are positioned.