 Implosion of the long crude oil/short dollar trade
by Kevin Pendley
I think the first time it cost $50 to fill my gas tank was when it truly dawned on me that the relentless rise in energy prices could literally impact the quality of my life. About four years ago, one of the smartest men I've ever known asked me a simple question. His query? "Kevin, do you know how much I would pay to fill my car with gas?" I had no idea. This man can be tight with his money, but he's made a fortune through shrewd investments. His answer was jarring in simplicity. "Whatever it costs," he said. The next day he bought a broad basket of various energy and oil-related stocks. In essence, he was ahead of the curve by about two years on the most recent "macro" trade that has had everyone buzzing for months.
That macro trade involved buying crude oil futures or buy-side investments in other crude oil markets, while selling the U.S. dollar and/or shorting financial stocks, whatever your particular preference or area of expertise. In about 18 months, crude oil prices have gone up some 140% to the July peak. In that same time frame, the dollar has collapsed 18% against the euro and the S&P 500 went into a 23% tailspin off the highs.
It has been widely reported that hedge funds latched onto this trade like a pit bull terrier and then rode out the profits. I picture those hedge fund managers who correctly timed this trade buying entire islands in the Caribbean as summer vacation villas, but word on the street is that hedge funds are now starting to squirm and that the implosion of the long crude/short U.S. asset trade in recent days could trigger an unwinding of epic proportion, sending the dollar and equities into a rally frenzy and crude oil into the tank. For perspective, at the time this column was written, crude oil futures were off about $22 dollars a barrel from the all-time highs or 17% in just a matter of a couple of weeks. Meanwhile, the dollar was up about 1.2% from last week when I wrote this column and the stock market rallied back from the brink of disaster, climbing 5% off the July lows.
While it's true that unwinding of this macro trade has undoubtedly played a role in recent price swings for these assets, the impact has likely been overblown. Trust me, if everyone is talking about something in financial markets, the eye of the storm front has already come and gone. Even as the Commodity Futures Trading Commission has been forced by regulators and politicians to deliver scapegoats for the energy surge and to tighten regulation on speculative trading … guess what's been going on in the true "guts" of crude oil futures? Open interest, which signifies outstanding contracts, has been on the decline and is rapidly approaching 18-month lows. You tell me; if there is significant unwinding of hedge fund longs still to be executed, then why is the number of outstanding contracts near 18-month lows? HOT MONEY TRADERS HAVE ALREADY MOVED ON TO THE NEXT BIG TRADE! And don't get me started on the absolute insanity of trying to put trading curbs on commodity market speculation. Commodity markets are bigger than hedge funds. Commodity markets are bigger than small investors taking a risk on an attractive story. Floods in the Midwest send corn prices to record highs? What is wrong with investors utilizing derivative instruments to trade on that story? When political pundits with very little market knowledge start trying to blame commodity price inflation on speculators, things are out of whack. Would they start instituting buy-side curbs on equities because the stock market goes too high? OK, rant over. Let's talk about what these latest reversals in long crude/short U.S. assets mean to the short-term trading horizon.
First, the greenback appears to have bottomed, both against the euro and against a basket of other currency markets. Although I don't believe that we still have massive unwinding of the crude/dollar macro trade left to go, I do believe that there is room for further dollar appreciation and that the euro looks very top-heavy. If the short equities side of the macro trade still has room to run, then that will only further support the U.S. dollar by moving money into the stock market.
Updating our current trade recommendations, our short euro/dollar trade and short euro/sterling trades from last week turned into attractive winning positions. I will adjust our stops downward to protect profits just in case things reverse into next week's action.
FX COLUMN TRADE CONCEPT RECAP
DATE CONCEPT PRICE THEN/NOW PROFIT/LOSS COMMENT
4/24/08 Short euro/dollar entered @ 1.5682 +0.52% stopped out at 1.5600
5/01/08 Short euro/yen entered @ 161.50 +0.12% stopped out at 161.30
5/08/08 Short euro/Canada entered @ 1.5680 +1.46% profit taken @ 1.5450
5/15/08 Short euro/yen entered @ 162.40 -0.36% stopped out at 163.01
5/29/08 Short euro/dollar entered @ 1.5525 -0.55% stopped out at 1.5610
6/10/08 Short euro/dollar entered @ 1.5682 +0.99% stopped out @ 1.5610
6/19/08 Short Aussie/dollar entered @ 0.9600 -0.49% stopped out @ 0.9670
7/03/08 Short euro/dollar entered @ 1.5750 -0.64% stopped out @ 1.5851
7/18/08 Short euro/dollar entered @ 1.5885/1.5650 +1.47% stops @ 1.585
17/18/08 Short euro/sterling entered @ 0.7920/ 0.7890 +0.37% stops @ 0.7951
Kevin Pendley has been involved in financial and commodity markets for two decades, including more than 15 years with Knight-Ridder Financial News/BridgeNews. In addition to his work at 4xAdviser.com Weekly, he is a contributor at SmallCapInvestor.com where he writes a weekly technical analysis column on the Russell 2000.
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