Watch Out for a Counter-Trend Rally in the Dollar Index

 | Sep 11, 2017 | 6:00 AM EDT
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While the market indexes did fall last week based on the extreme overbought condition we had going into the week, there is more to the story than that. Two months ago, in mid-July, the S&P 500 closed at 2460. It currently stands at 2460. In mid-June, it stood at 2450 as well. So it's not as though the last three months have seen a lot of action.

The real action in the last few months has been in currencies and bonds (and commodities too). This is where we see some extremes. For example, the Daily Sentiment Index (DSI) for the euro stands at 93%. As a reminder, this measures the percentage of bullish indicators. So if you flip it around, that means a mere 7% of indicators are bearish the euro.

Using the chart of CurrencyShares® Euro ETF (FXE) , an ETF to be long the euro, you can see why folks are so bullish. But take a closer look and notice that the 93% reading arrived late last week and still FXE hasn't surged to a higher high; rather, it sits at the previous high.

Last week, the Bank of Canada hiked interest rates, so it is no surprise that the Canadian dollar has surged. Using the chart of CurrencyShares® Canadian Dollar ETF (FXC) , we can see the extraordinary rise. The DSI for the Loonie is now at 93% as well. Is the boat too loaded in one direction?

Then, there is the Japanese yen. This is a lovely chart, where it appears to be breaking out of a base. There is no real resistance on the chart of CurrencyShares Japanese Yen Trust (FXY) until it gets into the $90-$91 area. Yet the DSI for the yen is currently 95%. I suppose it can get to 100%, although I have never seen it go much higher than the upper $90s. To show you how extreme it has gotten, the red arrow on the chart from early July 2016 shows the last time the DSI was 95%. There was quite a pullback to shake out the bullishness.

Of course, there is one common theme in all of this: the weak dollar. It has been in a steady downtrend all year, and there is nothing pretty about that chart. I have tried to catch a countertrend rally in the buck a few times this year, to no avail. The bounces have been small and short lived.

On the chart of Powershares DB US Dollar Index Bullish Fund (UUP) , an ETF to be long the Dollar Index, the red arrow represents the last time the DSI for the Dollar Index got to single digits (6%). You can see there was a bounce. It lasted a mere two weeks before it was over. Today's DSI is at 7%, so here again, it's hard to imagine we don't see some sort of counter-trend rally this week.

What is amazing is thus far these outsized currency moves over the course of the last few months have had no effect on the stock indexes here in the U.S., except to keep them sideways. Therefore, it's hard to say whether a counter-trend move would matter to the indexes, so let's just say it's quite uncommon to have such big currency moves and the markets yawn. Keep this on your radar.

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