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Has the US Dollar Bottomed?

Currencies / US Dollar Jun 03, 2008 - 11:09 AM GMT

By: Money_and_Markets

Currencies

Best Financial Markets Analysis ArticleJack Crooks writes: It's my job to analyze the markets, turn them upside down, inside out, and always consider both sides of the story.

That's the only way to make informed trading decisions, and to make sure the odds are tipped in your favor as much as possible.


Take the U.S. dollar, for example. There are strong arguments being made from both the bulls and the bears. Today I want to examine both sides, and tell you which one is more convincing based on the current evidence.

Let's start with ...

Why Bulls Say the U.S. Dollar Has Bottomed

Reason #1. This dollar bear market is about seven years old. What difference does that make? Well, the last two major bear markets in the U.S. dollar lasted ... seven years.

Take a look at my long-term chart of the dollar index. Going back to 1971, the year President Richard Nixon took the dollar off the gold standard, I have marked the three major bear market cycles in the dollar.

Dollar Index -- Long Term

So dollar bulls will say that history is repeating itself and that this seventh year of the current dollar bear will be the last.

#2. The supply of dollars is falling as the U.S. current account deficit improves. Because the major currencies are free-floating, prices are determined in the market based on the global supply and demand for a particular currency against another.

And one of the major sources of supply of U.S. dollars is through the U.S. current account deficit.

Now, the U.S. current account deficit is improving. That means less dollars in global markets, which should help the buck's value.

But here's an interesting side note: The last two times the U.S. current account deficit improved, and dollar liquidity drained from the global economy, there were major stock market crashes and recessions. Will the same thing happen this time around?

The chart below shows the U.S. current account going back to 1960. I have circled on the chart the last two-times the U.S. current account improved, and the last several months which show a similar improvement. (The gray lines represent recessions.)

Balance on Current Account

Reason #3. Expectations are now so low, the greenback can only go up. The market is a discounting mechanism. That means all known information is already factored into the price. In addition, currencies are always priced relative to other currencies.

So if one currency is already priced for Armageddon, and another currency is priced for perfection, it only takes a slight shift in news to send prices heading in opposite directions.

The dollar bulls will say that since everyone hates the dollar right now, it is already priced for disaster. Any hint of positive news could send it up.

Reason #4. Historically speaking the dollar is undervalued. Currency markets are very driven by sentiment. Investors believe something and start piling into a trend. Then, that activity draws more and more believers out of the woodwork.

This is why we often see currencies overshoot their fundamental values by a large margin during major trends.

And now, the dollar is approximately 30-34% fundamentally undervalued against the euro, its major competitor currency.

The last time we saw this level of undervaluation in the U.S. dollar vs. the euro (then the German D-mark) was back in 1982, just before the dollar launched into a major bull market.

So there you have it ... four reasons for a dollar bottom. But not so fast, bulls ...

Why There Is More Room For the Dollar to Fall ...

There are three nagging reasons why I am still cautious about saying with any degree of certainty that we've seen the bottom.

First, interest rates are still out of whack. The yield differential for the dollar against the euro has turned negative. And it seems the European Central Bank will remain hawkish in the face of rising inflation expectations. Ditto for the Bank of England and the Reserve Bank of Australia.

Translation: Even though the U.S. Fed may be done cutting, it doesn't mean the interest rate differentials that currently favor other major currencies will change anytime soon.

In fact, if we view the real interest rates of all the major currencies compared to the dollar, the buck comes in dead last! [To derive the real interest rate, you simply take the current interest rate and subtract the inflation rate.]

Yield and Inflation Comparison — Major Currencies

3-mo % Yld
Inflation
Real Yield
Australia
7.8
4.2
3.6
UK
5.8
3.0
2.8
Euro-zone
4.9
3.3
1.6
Canada
2.7
1.4
1.3
Switzerland
2.8
2.3
0.5
Japan
0.8
1.2
-0.5
U.S .
2.0
3.9
-1.9
Source: The Economist

Second, the credit crunch may not be over. I think it is too early to say the U.S. economy is safe from the lingering impact caused by the credit crunch.

Sure, things have improved since the Fed's bailout of Bear Stearns. But we could be entering a second stage of the crisis.

Reason: The major financial institutions may be past the crisis stage, but they still need to clean up their balance sheets, get rid of bad loans, and unwind derivative contracts that are still out there.

In short, we could see subpar economic growth for years to come. And the U.S. dollar is the currency that gets hit the hardest when risk increases in the global economy. If credit concerns linger, it will most likely weigh on the greenback.

Third, overall positioning doesn't support a major trend change . No doubt most people you talk with, read, or listen to are bearish on the U.S. dollar. I call them "talking bears."

Euro Futures

I'm more concerned with the "acting bears," or those who have placed real money on the table. At major turning points, active bears are at an extreme. Everyone who wants to be short the dollar is !

The best way to see this is by looking at the open interest levels in the currency futures markets. Take a look at my chart of the euro futures.

As you can see, open interest has been high, but an extreme in open interest has not corresponded to a high in the euro. If we are at or near a major turning point, I would expect to see that.

So there you have it. There's light at the end of the tunnel for the greenback, but the tunnel could go on for some time first.

I remain short-term bearish on the dollar. Longer-term investors (12-18 months out), probably have a greater chance of success betting on the buck.

Best wishes,

Jack

This investment news is brought to you by Money and Markets . Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit http://www.moneyandmarkets.com .

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