How much further can the US dollar fall?
By
Dominic Frisby Aug 04, 2010
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The fall in the US dollar over the past two months has been simply breathtaking.
The US Dollar Index measures the dollar against a basket of foreign currencies: the euro, the pound, the Canadian dollar, the Swiss franc, the Japanese yen and the Swedish kroner.
The index rose astonishingly quickly from 80 in April to 89 by early June, as panic over Greece overwhelmed the euro. But it has since turned tail and retraced all those gains as quickly as it made them.
In fact, the dollar had better turn up pretty soon or we'll have a rout on our hands...
Why is the dollar falling?
Let's start with a chart of the US dollar over the last six months, showing the rebound. You'll often hear pundits hedging their bets on an asset class, saying, "It could go up or it could go down". Well, this one has done both - straight up and then straight back down again. A 10% swing may not seem like much, but for a currency as significant as the US dollar, it's a big deal.
Why the reversal? Much of it must be down to the sudden sea-change in economic attitude that's taken place over the past few months. Up until summer 2010, the Keynesians had the upper hand. There was a widespread belief that bail-outs and suppressed interest rates were the correct way forward.
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Now, suddenly - and our own government has played a big part in this - the 'Austerian' school of belt-tightening, efficiency, and paying down debt has become de rigeur. At least, it has in the UK and Europe.
In the States there's also a genuine appetite for such measures. This in part is what the Tea Party political movement is about. But Ben Bernanke and Barack Obama have no plans to satisfy that appetite. While the US remains bent on its Keynesian course of unchecked spending in the face of austerity elsewhere, the US dollar will be a casualty. I mean, my goodness, even the basket case that was the pound is now a respectable international currency once again.
And how far will it drop?
But how far does the US dollar have to fall? That's the big question. And I'm in two minds about it. I suspect that much will be determined by the results of the upcoming US mid-term elections, and what the markets expect the outcome to be in the months and weeks leading up to them.
If the polls show the (marginally) more fiscally sane Republicans re-taking the house, I would have thought that should restore some dollar confidence. This isn't dissimilar to the way the pound behaved before our election over here: Where to now for the pound?
Looking at some possible other bullish catalysts for the dollar, I turn to the stock market, which remains volatile. On Monday, for example, the FTSE was up over 100 points - the Dow Jones, 200 points.
That might sound like good news. But when markets rise with such force and velocity, it's usually symptomatic of a bear market rally, with traders rushing to cover short positions, rather than a healthy bull market. The crash of 2008, for example, featured several record 'up' days.
If the current volatility is a harbinger of some big declines - and my suspicion is that we'll see some really big ones - then that would likely result in a rush to cash and, in particular, the dollar.
Secondly, against some currencies, the US dollar is at extreme levels. I posted this chart of the Japanese yen a few weeks back: The best-looking currency trade you can make today. The dollar has never been so weak against it, except for a brief few weeks in 1995.
Based on this, I suggested that the odds favoured a reversal, so perhaps you should go long the dollar versus the yen, with a stop somewhere above the red line on the chart below. The trade is just about intact, but only just.
And against the pound and the euro, the dollar is also reaching levels where turns have happened in the past. These are $1.60 against the pound, and $1.325 against the euro. Monday's action in the dollar was reaching 'blow-off' levels, and the dollar has declined for eight weeks in a row. So it's possible that we may see some sort of turn - or at least some respite - imminently.
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But take a step back and look at the weekly chart of the dollar index (below). This shows that further falls (though not necessarily against the yen) look somewhat more likely. That lower trendline I have drawn in green, around the 76 mark, seems to be beckoning.
The dollar has found temporary support around the 80 mark, or just below, in the past. Perhaps it could do so again around its 52-week moving average (the average price of the previous 52 weeks). But the speed and ferocity of these recent declines suggest there could well be more to come.
America could be set to face inflation again
If we get back to that lower trendline - which would be about a 5% fall from here - then there will be rumblings of concern. If we retest the all-time lows of spring 2008 - and we have a way to go (more than 10%) before we do, then those rumblings will become shouting and panic in some quarters. The pendulum will have swung once again - for the Americans at least - from deflation to inflation.
Fall much further than that and suddenly the US goes from inflation to runaway inflation. The electorate will be clamouring for another Paul Volcker and the market will no longer allow the US to suppress its interest rates. That's when things could get really interesting.
If I had to commit to one particular side, I'd be betting on some kind of reversal in the dollar, at least in the short term, against both the pound and the euro. It was from just these levels that the dollar reversed in late 2008. But it's not a trade I'd be committing vast sums to. As far as my dollar vs the yen trade goes, however, I'm sticking to my guns.
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Dominic Frisby
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