It’s time to sell EUR/USD and stay with the trade. Could it be that crude is suffering from a reality bite? The reality is that the big four in the developed world, the United States, United Kingdom, Euro zone and Japan are staring into the face of recession. Add to this reality the slowing Chinese growth, with the potential for a negative surprise flowing from the impact of closing of factories (front-end loading parts and inventory production in the prior quarter) to clean the air for the games, oil could go much lower than expected if demand is the driver we think it is. In our opinion, because of the tight price and fundamental correlation between crude and the dollar in this cycle, it bodes very well for the greenback. And it sets up the opportunity for a long-term short of the most overvalued major currency: the euro.
In our view, falling crude prices will represent the raw material for the Euro zone and Bank of England to cut interest rates. We say raw material because it could be just what’s needed to reduce, or at least stabilize, headline inflation, which is the only reason why rates haven’t tumbled along with the respective economic growth in Europe.
And in case no one noticed, the United States grew faster than the other big major economies in the second quarter despite all its supposed warts. So if rates come down quickly in Europe and the United Kingdom, it could dramatically change the yield and growth differential picture in favor of the buck.
Below is the visual connection that we have coined the Oil – Dollar Support Equation.We have more than a piece of theory to add to the Oil – Dollar Support Equation that could represent major long-term buying support for the dollar: Though we cannot define the numbers, we do believe many countries have been borrowing larger and larger amounts of dollars to pay for oil, and because oil is priced in dollars, it has made sense. Borrow dollars to buy crude and pay back those loans with cheaper dollars. We call this the $-Crude Carry Trade.
A change of dollar and oil trend makes the $-Crude Carry Trade look like a very bad idea. In fact, it should lead to more buying back dollars to repay dollar loans. It is an end to the $-Crude Carry Trade and more fuel for a dollar rally.
And you probably already know what major currency has moved in lock step with crude oil: the euro. Most analysts agree the euro is about 30% overvalued on a purchasing power parity basis (a global fundamental valuation measure). A break in oil will launch the single currency a lot closer to its true valuation, which incidentally stands around $1.12. Even if we are half right, this could be a very good trade setup for those with patience and staying power.
Jack Ross Crooks Jr.
Black Swan Capital
