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A surprisingly weak non-farm payrolls report sent the U.S. dollar sharply lower at the end of last week, as traders bet the Federal Reserve would have to put off rate hikes on an uncertain economic outlook. Following the news, the dollar plunged 1.6% against a basket of major currencies, and bond prices jumped on the prospect that low rates will persist at least until the Federal Open Market Committee (FOMC) meets in July.
The odds of a June rate hike have fallen to just 4% from 34% a month ago, according to the CME FedWatch tool. The market is now pricing in a 29% chance of an interest rate increase in July and a 46% chance of a hike by the Fed's Sept. 21 meeting.
But dollar strength could return just as quickly as sentiment weakened, and the market is overlooking fundamental and technical factors that could send it shooting higher.
For nearly two years, a strong dollar has exacerbated the plunge in the price of oil and wreaked havoc on corporate profits. But rather than being the start of a downward trend in the greenback, the recent sell-off may be an opportunity for investors to go long the buck and profit from strength to come.
Central Bank Divergence Still the Name of the Game
U.S. employers added just 38,000 jobs last month, the smallest number in almost six years and well below the 164,000 economists were expecting.
Fed Chair Janet Yellen provided little clarity on the outlook for rates in a speech on Monday. She noted, "I see good reasons to expect that the positive forces supporting employment growth and higher inflation will continue to outweigh the negative ones," but provided no timeline for rate hikes.
The bigger issue, though, is the fundamental disconnect between the current monetary policy of the Federal Reserve and central banks in other developed markets. While the Fed may now have to raise rates more gradually than even previously anticipated, the European Central Bank (ECB) and Bank of Japan are still firmly in easing mode.
The ECB left rates unchanged earlier this month and began its first corporate bond purchasing program this week. The ECB has cut rates four times in the past two years, and government bond yields in Europe are near all-time lows.
The Bank of Japan starts its two-day meeting June 15, with a close advisor to Prime Minister Shinzo Abe calling for an expansion to monetary stimulus. Japan's 10-year government bond has a negative yield.
The divergence in central bank policy and the effect on rates represents huge fundamental support for the dollar. Foreign investors are scrambling for yield and safety amid stagnant economic growth, so the 1.68% yield on the 10-year U.S. Treasury note is extremely attractive. Buying Treasury notes means buying dollars, and it is a trend that looks set to continue at least through the rest of the year.
Demand for the 10-year bond is keeping long-term rates low even as shorter-term rates creep higher. This is causing the yield curve to flatten, usually a harbinger of recession, and could scare investors into safer assets like the dollar.
Technical and Smart Money Support in Play
From a technical perspective, the U.S. Dollar Index is approaching oversold conditions based on the 14-day Relative Strength Index (RSI), shown at the bottom of the chart below. Prior to the employment report, it was approaching overbought readings.
The index is also holding support just under 94 from the 20-day price channel. While Friday's employment report sent the dollar reeling, it's notable that it didn't break through the lower boundary of the price channel. While the index did dip below that level this week, it recovered to close above it on Thursday.
Finally, the smart-money players, i.e., hedge funds and speculators, expect dollar strength to return, according to the most recent Commodity Futures Trading Commission's Commitments of Traders (COT) report. As of May 31, they had a net long position of 84,149 in dollar contracts. The bets on a stronger dollar are the highest since March 22, and a survey of analysts by Bloomberg shows the market expects a stronger greenback by the end of the year.
Amplify a 2.7% Move Into a 61% Return
The PowerShares DB US Dollar Index Bullish Fund (NYSE: UUP) tracks the U.S. dollar against the euro, Japanese yen, British pound, Canadian dollar, Swedish krona and Swiss franc. The ETF is very liquid, with an average of nearly 1.5 million shares traded daily.
ETFs are known for making smaller moves than stocks. For instance, UUP has traded in a roughly $2 range for the past 12 months. That's why I routinely turn to call options to amplify smaller ETF moves into huge gains.
With UUP trading at $24.34 at the time of this writing, we can buy a UUP Sep 24 Call for about $0.62 per share ($62 per contract, which controls 100 shares). Our breakeven price is $24.62 ($24 strike price plus $0.62 option premium), which is just 1.2% higher than the market price. Plus, the call costs only a fraction of what it would cost to purchase 100 shares of UUP outright.
My upside target for UUP is $25, which is just 2.7% above the current price and almost smack dab in the middle of its 52-week range. If shares hit my target before the option expires on Sept. 16, the call will be worth at least $1 ($25 stock price minus $24 strike price) for a 61.3% return in 99 days. Set a good 'til cancelled (GTC) sell order at $1 for the option after opening the position.
The dollar bulls were dealt a blow last week, but the overall trend supports strength through the rest of the year. Diverging central bank policy will keep foreign investors scrambling for yield in U.S. Treasuries, and technical factors should support the greenback in the short term. A long dollar position should help traders hedge weakness in corporate profits from overseas sales and benefit from a rally in safety assets if the stock market wobbles.
Before I sign off, I mentioned call options were a great way to amplify returns in ETFs. Just look at the table below:
These were all trades recommended by Profit Amplifier's Jared Levy. We normally charge $1,000 per year for Jared's service. But if you try it today, we'll give you full access at our one-time, month-of-June introductory rate of just $49 a month.
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