Overview

Over the past 18 months, the inverse relationship between the US dollar and global equities markets has proven to be the single constant in an otherwise uncertain economic climate. When equities markets reached their nadir in March, 2009, the US dollar was sitting atop its highest levels, though much of that value would be lost in the equities-rebound that would follow.

Since December of last year, the US dollar has again exhibited tremendous strength, most notably against the euro and the sterling, yet equities markets remain generally unscathed. Though some might view this recent divergence as evidence of a changing relationship between the two asset classes, the more probable explanation is that this divergence is a temporary event doomed to be corrected; that is to say, we are bearing witness to The Dollar Prophecy signaling an imminent decline for equities markets.

The Euro

Weighing heaviest on investors of late is the ongoing turmoil in the eurozone, where the potential for credit downgrades and defaults on debt are a daily concern. Earlier today, Fitch Ratings downgraded the creditworthiness of Portugal to AA-, issuing a negative outlook that may lead to a second downgrade down the line.

More prominent, however, are the concerns surrounding Greece's debt obligations and the failure of the EU to allay those fears through some form of resolution. During a radio interview with Bloomberg earlier today, UBS deputy head of global economics stated that a Greece default on its debt obligations will occur at some point. He continued:

I think it's in an impossible situation. ... Europe has failed to clear its first serious hurdle. If Europe can't solve a small problem like this, how on earth is it going to solve the larger problem, which is the euro doesn't work. It's a bad idea.

In trading today, the euro remained in free fall mode, lacking both the fundamental and technical supports needed for a reversal. The chart below of the euro (FXE) overlaying the emerging markets index (EEM) clearly depicts the downward pressure that the currency is facing as well as its relationship to gloabl equities.

Note as well the December divergence between the euro and the emerging markets index and the price action that follows. While the EEM remains near its recent highs, it appears to be struggling to make fresh ones, potentially signaling the imminent correction that The Dollar Prophecy would predict.

The Sterling

While the eurozone has dominated headlines in recent weeks, the UK economy deserves its fair share of coverage as well. Speaking days ago during a CNBC interview, Bank of England policy maker, Andrew Sentance, called attention to the risk of a double-dip recession in the UK:

I have to recognize that there is some risk of a double dip recession but it is not the central forecast, Sentence said. We would have to see some factors that would bring that about.

While Sentance maintained a relatively upbeat front vis-à-vis the UK economy, stating that a double-dip was unlikely, barring any big shocks internationally, the same cannot be said about the futures market, which overwhelmingly favors the double-dip scenario. In fact, as Bloomberg recently reported, Sterling bears outnumber their bullish counterparts by a margin exceeding that which existed when George Soros took down the Bank of England - and by a factor of 8, no less. Add to that a budget deficit in the UK at which even Greece would balk and the sterling's downward spiral begins to makes sense.

The chart below depicts the sterling (FXB) against the emerging markets index.

As with the euro, the sterling's downtrend resumes in December, 2009, at which point it diverges with the EEM. Once again, The Dollar Prophecy would predict a correcting EEM and the resumption of the inverse relationship between the US dollar and global equities.

The Trade

There are two ways in which traders might take advantage of The Dollar Prophecy. For those with a strong directional bias, the trade is simple: short the GBP/USD and/or the EUR/USD. In fact, the diehard bears among you may go so far as to buy puts on the EEM as well, betting that the index will lose value.

Alternatively, one might employ a more nuanced, mean reversion strategy. In this case, the trade has two legs. The first leg is to buy puts on the EEM, betting again that the price of the index will fall. The second leg is to buy the GBP/USD and/or the EUR/USD. The expectation for this trade is that the values of the index and the currencies will begin to converge.

Portugal United kingdom U.S.