The dollar is seriously oversold and 'should' correct

Outlook:

The dollar is seriously oversold against every other currency and "should" correct. We see some indications of that, against the CAD, for example. But some indications are not adding up to a preponderance of the evidence, which is what we really need to name a change, however temporary, in sentiment. Just when a correction is nascent, something comes along to wreck it.

The FT reports the dollar is getting dumped because of Trump. ING writes that the market sees the US cycle topping out and without the Trump Bump, likely to push US asset prices down. Second is overall political risk based on Trump's incompetence and erratic behavior, "certainly one explanation for why the dollar sharply decoupled from interest rate differentials in recent weeks."

We see two huge issues looming and likely to become headlines any day now. First is the trade war with China, presumably in retaliation for China failing to rein in its client state, N. Korea. This is a bit childish and a departure from the usual US "diplomatic" route, but it's also what Trump promised during the campaign. Trump is not wrong that the US has been fairly wussy on trade—lots of cases at the WTO but not enough and not big enough considering the deficit. In May, the US deficit was $46.5 billion and the deficit with China was the main portion, $30.1% billion, or 65%.

It's conceivable that the threat is supposed to be Trump's starting position to intimidate the other side, as a negotiating tactic. Or Trump could just go full-speed ahead to appear macho. You never know with this guy. One question is whether the WTO is brought in or Trump goes it alone. On recent behavior, we'd say the process gets quite far before Trump ends up at the WTO, parallel to the NATO experience. Well, a trade war with China takes the heat off NAFTA—for a while.

The second big issue is the debt ceiling, which will get reached on Sept 29, according to the Treasury. Congress has to pass a bill extending the debt ceiling by then and presumably raising it, too. In years past, efforts to pass a balanced budget bill have come to naught, but there are plenty of legislators and voters who are deeply unhappy about the debt-to-GDP. Trump is not really a conservative—he doesn't care about the deficit. In fact, he loves debt, claims he knows more about it than the bankers (just as he knew more about ISIS than the generals), and is not at all bothered about default.

Now put these two things together—a fight with China, the second largest holder of Treasuries, plus a potential government shut-down or default. China will not be alone in dumping dollar-denominated assets, including Treasuries. We call this the nightmare scenario and wrote about it the first week after Trump got elected.

It's funny that Switzerland could join China in dumping US assets. The SNB has accumulated a reserve stockpile of $750 billion allocated to stocks, bonds and cash. Intervention has its virtues. The WSJ re-ports SNB's profit last year was Chf 24.5 billion or about $3,000 per Swiss resident. Nobody knows quite what to do with the pot of gold and it's hotly debated within Switzerland. A current pending bill would specify distribution and investment purpose. Using the money to build roads at home would have the opposite effect of what the SNB wants—keeping the CHF down.

The SNB owns mostly Swiss bonds but also equities worldwide, with a heavy chunk in the US. See the chart. Who knew the SNB was such a big investor in Apple? How would you feel about this if you were a Swiss citizen? Fireworks ahead.

But the SNB is smart to have so much in dollars and in the US stock market. The dollar may be weak, but it's precisely the weak dollar that is gutting foreign stock markets—to the extent those companies rely on exports. The FT notes "A surprise fall in the U.S. dollar is taking the fizz out of international stock markets and prompting investors to damp overseas expectations for the months ahead.

"European and Japanese benchmarks—which were among the world's best performers in the spring—have lagged behind the S&P 500 since the dollar fully erased its postelection rally two months ago. An-alysts are cutting their earnings forecasts for companies in these regions as the dollar's unexpected drop has upended more optimistic projections.

"Overseas stock markets are already reflecting the trend. Despite a buoyant global economy, the Stoxx Europe 600 has fallen 3.4% in local-currency terms and the U.K.'s FTSE 100 has dropped 1.7% since the dollar fell back to its pre-election value on May 22. The S&P 500, meanwhile, has notched a 3.2% gain over that period.

"... Bank analysts project a fall of roughly 4% to 5% in eurozone profits for every 10% rise in the eu-ro."

"Swings in the euro have historically been a key driver of earnings beats, with a weaker euro prompting better results." It can lag for quite a while, but eventually will hit "large-cap automotive, technology, food and beverage, and personal and household goods companies, which generate more than half of their revenues overseas."

And it's not just the euro. The Nikkei is correlated with the dollar/yen the most of all the indices, about 90%. And falling since July. Meanwhile, emerging market companies do okay—unless they hold a lot of dollar-denominated debt.

To finish off, get ready for Friday and nonfarm payrolls. Today we get the ADP estimate for the private sector, not very good but better than nothing. The forecast for the forecast is 190,000 (it was 158,000 las time and then we got 220,00). Remember that for some reason we can't explain, the dollar often rises on the Wednesday before payrolls. Maybe not this time. And keep in mind that a deeply oversold condition breeds volatility that prefigures a correction. Prices simply don't move in a single direction for very long. But identifying a true correction has been nothing but misery for the past three months.

See the weekly chart. The euro has not even regained 50% of the giant drop from 2014.