USO / Oil Update, the Carry Trade ($USD-Broad market too).

Yesterday after the close API oil inventories came out with a 4.2 million barrel bill versus consensus of 3.3 million barrels and a Cushing Storage facility draw of -162,000 barrels. This was a new record, Being the 16th consecutive Weekly build. Crude futures saw a dip right after the API data and some further weakness overnight.

This morning's Department of Energy EIA petroleum report showed another record build, again at 16 consecutive weeks with 1.9 million barrels, coming in below consensus of 3.2 million barrels. Cushing saw inventories decline buy -514,000 barrels last week, still the total inventories set a new record with 16 consecutive weeks of builds.

USO tried to break out above its base's resistance level today on the lower than expected build and Cushing draw. I wanted to update this earlier but was too busy with the other market events.

Before I get into USO specifically I wanted to show the correlation between the $USD and Brent crude futures (some as WTI), as my earlier post today, $USD Update dealt with the probability of the $USD primary trend breaking as it has posted a lower high and now a lower low both on a closing and an intraday basis.

In the $USD update, I mentioned the probability of a corrective countertrend bounce. I intend to show the $USD correlation to oil as part of this USO update, but while I am at it I figured I would also show the correlation with the broad market given very near term analysis.

There is some confusion about the $USD correlation to dollars denominated assets. The historical "Legacy Arbitrage" correlation is like Newtonian law. It's very simple, if the US dollar rises then US dollar denominated assets fall (gold/precious metals, oil, even equities). Likewise if the US dollar falls, oil producers have to charge more to make up for the weakness in the dollar. That is the simple historical correlation. However, when a USD Carry trade is in effect such as current (near $Trillion USD carry) carry trade, then often you will see the market move with the USD as we have so many times in the past via USD/JPY. As you know, whenUSD/JPY has risen, market has followed it in near lockstep. This is because the carry trade is in effect. 

Without getting into too much detail, an investor sells a certain currency with a relatively low rate of interest and uses the funds to purchase a different currency yielding a higher interest rate and captures the difference between the rates. Since the USDJPY is the granddaddy of carry trades currently, here's an example:

A trader/Institution borrows Japanese yen from a bank at near zero interest and converts the yen in to $USD and buys the equivalent amount of an asset, typically a high quality bond. Monetary stimulus in Japan creates a cheaper yen, and thus a stronger dollar. The bond's interest rate is more than the cost of borrowing the yen producing a positive carry due to the interest rate differential. The buying drives up $US bond prices as we saw them outperform equities last year. Typically this is done at 100:1 to 300:1 leverage so profits can be huge assuming the Yen doesn't rise. Additionally the rise in the $USD  and/or US Treasuries contributes to extra gains, creating a self-fulfilling feed-back loop.Money is made on the positive carry, the rise in the $USD/fall in Yen, rise in US treasuries.

Gains are (or have been) reinvested in the stock market chasing the highest yield, thus the carry trade, while not specifically material to oil (although there are obviously effects such as commodities tend to fall), has a very specific magnetism on bonds, equities and Emerging markets (more on that below) given so much of the approx. $9 trillion in $USD carry has been invested at some point in the US equity markets. 

So long as the differential remains fairly constant and the yen is yielding less than the USD, the trader captures the difference between the rates. This is often done at 100:1 to 300:1 times leverage and many funds use the carry trade to leverage up their AUM (Assets Under Management)

Emerging markets have benefited from the carry as well. Lower-interest currencies of countries like Japan or the U.S. are borrowed and invested in the much higher-yielding bonds of emerging market countries. Of course as we have seen over the years with hedge fund holdouts with past Greek debt deal reconstruction, the danger is that when one of these countries has trouble paying the interest on its debt, there is a huge unwinding of this trade and an emerging market crisis produces a world-wide market crash. This is precisely what happened in 1997 and 1998. The emerging markets carry trade is estimated to be at least $2 trillion and as much as $5.7 trillion in size.

So we know that the $USD, bonds and equity prices tend to gain in a carry on environment and the same tend to fall in a carry off environment. Throw Emerging Markets in there as well.

What do you make of this?

 The daily chart of the $USDX with a leading negative 3C divergence. The two yellow trendiness denote the first time in this primary trend the $USD has failed to make a higher high and has now made a lower low. Does that tell you anything considering what I just wrote about the carry trade and what the symptoms of its unwind are?

 Since we know significant carry profits went in to financing stock purchases, how about this daily chart of the SPX? Note any changes in character or trend?

You might recall toward the end of last year I expressed concerns that the long term strategic 3C charts were no longer confirming TLT (20+ year bond fund) and since it has made a lower high and is very close to a lower low as well.

You know which currency is a favorite as a pair for the USD carry trade, the Japanese Yen so what about this daily chart of Yen futures and the 3C signal being given currently?

 Not only has the Yen's trend changed from down to sideways, just as we see when stage 4 decline ends and a new stage 1 base begins, but 3C is showing a positive divergence on an extremely strong 1-day chart.

Or as we have been talking a lot about 2015 triangles, how about this bottom triangle in the Yen, remembering it trades nearly opposite the market and that large triangles are not consolidation/continuation price patterns, but rather most often tops or bottoms depending on the preceding trend, this would be considered a bottom..

So just why is the $USD falling apart and the Yen gaining strength?

Well I don't want to make any definitive statement here, but to unwind the carry trade, bonds, equities, etc (that were bought with carry trade assets) are typically unwound, then the original currency that was borrowed has to be repaid, in this case the Yen. This is VERY simple supply and demand dynamics and likely on a scale in to the trillions.

As for those triangles, this is the SPX.

I don't like making assumptions, but in this case I would say it is fairly safe to assume that the $USD global carry trade is being unwound which is often a dangerous, destructive process as the leverage is so high. He who sells first in this case, most definitely sells best, otherwise just as it snowballs up, it snowballs down with more velocity.

As to the $USD correlation with oil and the broad market.

 This is the 15 minute USD futures chart. Note the positive divergence from earlier on a 10 minute chart is now clear on a 15 minute chart, implying a strengthening divergence for what I suspect to be a countertrend bounce within the USD's larger decline as we have already seen once .

 This is the one minute USDX chart, while I typically would not suspect to a move up off such a small base area, the positive divergence does suggest a larger base area may follow; one capable of supporting a counter trend move.

Again, for more comprehensive charts and commentary on the USD and counter trend moves, See today's post, $USD Update

This 15 minute chart of the USDX (purple) versus ES (SPX futures) in candlesticks, shows the recent leading correlation the USD has had versus the market.

Thus, if we are to see a bounce in the USD, It would only make sense that the market sees some near-term support. However that's support may be greatly diminished due to the chart below.

 This 60 minute chart of the USD in purple versus ES shows the failure of the USD to make a higher high and is leading the broad market significantly lower as we expected at this point in the April 2 forecast (and what comes next).

 This is the $USD versus SPX futures(ES) on an intraday one minute chart. The correlation should be quite clear.

All of the above suggests that at a significant inflection point in the market in which the carry trade appears to appears to be in the middle of an unwind. Those caught on the back foot could see significant losses. If you haven't read about Long Term Capital Management, now might be a good time as the carry trade did not help their situation. As such I'm not very concerned about any near-term upside and if that is what you got out of this post, I would suggest looking at the chart just above this one once again.

As to oil...

 Brent crude oil futures are represented by the candlesticks and the $USD is in purple. Note the inverse relationship between the two and the more extreme downside move in the $USD, which oil failed to take advantage of on the upside.

 This is today's daily chart of USO hitting resistance as depicted with today's candlestick with a long upper wick on high-volume which typically denotes churning at resistance.

 I do like oil longer-term and this daily chart of Brent crude futures(CL) shows the negative divergence sending it lower as well as 3C's confirming Price/Trend signal at the green arrow as 3C makes lower lows with price. Finally the lateral trend change in oil on a leading positive 3C divergence and this on a very strong daily time frame.

You can see why I like USO as a long-term primary trend Core long position as we have been watching this develop all of this year. However I do believe that USO/oil can be had at better prices and lower risk.

Ironically one of the signs of a carry trade unwind is increasing prices in commodities such as oil.

 This is the hourly 3G chart of USO showing an initial divergence at resistance (the two red Xs) and a leading negative divergence since.

There is an excellent price trend confirmation otherwise and I have little reason to doubt this pullback signal especially as USO tries to gather a head of steam to break out of the base.

 This is a one hour chart of Brent crude futures showing the same negative divergence.

 USO 10 min at resistance (yellow).

 And the one minute chart showing the concept of 3C picking up where it left off as it formed a positive divergence in to yesterday's close, followed by a move higher on today's cash open. This is a concept that we have seen work time and time again, even over three-day weekends.

 The two minute chart shows a slightly weaker relative positive divergence yesterday as it was not strong enough to lead on a two minute chart. However the negative divergence in to today's gains is significant and showing the concept of migration or a strengthening divergence. This is also showing resistance at the trend line such as we saw above at the daily candle.

 And finally migration to the three-minute chart at trendline resistance. I still believe in the USO swing short position as well as May puts.

I believe once we get a pullback in USO. We should see accumulation at some point during a pullback confirming a constructive pullback and offering a low risk, lower entry price for what I believe will be a stage two break out from the 2015 base.

 This five minute crude futures chart is largely in line, But I suspect it will see migration from the one minute negative below.

Today's intraday one minute chart in crude futures showing distribution int o higher prices at resistance.

I know this is an odd post with a lot to take in, but I hope you find some use in it.