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US Dollar Bullish and Bearish Scenarios

Currencies / US Dollar Aug 04, 2008 - 01:54 AM GMT

By: Money_and_Markets


Best Financial Markets Analysis ArticleJack Crook writes: You can never actually know for sure what's going to happen on any given day, in any given market. And it's thinking you do know that can get you into real trouble.

Instead, you should think about the markets in terms of probabilities. I believe that is the real key to successful trading.

Here's how legendary trader Richard Wyckoff put it ... "Listen to What the Market Is Saying About Others Instead of What Others Are Saying About the Market"

In other words, you need to be open to information the market is sending you.

In short, we have forecasts, time-frames, and reasons, but if the market tells us those things are wrong — we should act. Let me give you a great example from this past Thursday:

  • U.S. second-quarter GDP growth undershot expectations ...
  • Weekly jobless claims overshot expectations ...
  • And capital started stampeding out of the dollar.

In a game of expectations, it seemed as though traders were ready to erase the dollar's latest rally and send it dramatically back to test all-time lows.

Turns out, it only took a few hours for the all-out dollar stampede to make a sharp U-turn.

In fact, the U.S. dollar index actually finished the session relatively flat from where it stood when the fireworks started.

In my opinion, this demonstrates two important points about the U.S. dollar right now:

  1. Currency traders are no longer convinced that the U.S. economy will worsen dramatically, and ...
  2. Currency traders are worried that Europe is on the verge of losing its relative advantage.

Critical to Thursday's whipsaw action was the anticipation of Friday's U.S. jobs report. We know now that jobs declined less than forecast even while unemployment jumped more than forecast in July.

The immediate reaction following the better-than-expected news was mostly positive for the greenback.

What about the dollar's longer-term prospects? I think we should look past the day-to-day action for that answer ...

This Year, the Dollar Is Down — So Is It a "Smile" or a "Frown?"

At the beginning of the year, I told you about a concept called the Dollar Smile . That idea offered up three potential scenarios for the greenback. Briefly:

1) The U.S. dollar appreciates on risk. In other words, the buck could ignore its weak fundamentals and rally on a flight to quality. This assumes foreign currencies and investments lose their appeal in the event of a global financial crisis. So far we have not seen this scenario play out.

2) The U.S. dollar appreciates on surprise growth. Clearly, this hasn't happened. Any positive surprises regarding the U.S. economy were few and far between. I ruled out this scenario in January, and I think it's safe to rule it out again. At least for the rest of this year.

3) The U.S. dollar falls as the U.S. economy muddles along. For the most part, this is exactly what has happened since January when I published the Dollar Smile concept here in Money and Markets . Each new month the economy revealed greater disappointment. And the U.S. dollar index has fallen as much as 7.8% since then.

Considering the way the dollar has been behaving over the last several weeks, I thought it would be good to go back and think about where we are with the dollar smile. In doing so I decided the environment is far different from the environment back in January.

With that in mind, I developed something a tad bit different from the dollar smile; something I think does a better job of offering up potential scenarios for the buck. Let's call it "the dollar frown."

Have a look at the following graphic. On top you'll find the Dollar Smile. It's a visual representation of how the dollar behaves based on the three scenarios I just described. On the bottom is the Dollar Frown. It's a representation of the three scenarios I'm about to lay out for you.

Dollar Smile and Dollar Frown

Scenario #1 — The U.S. dollar falls on risk. Again, if we look back to analyze the dollar's performance since January, we'll actually find that the buck has done poorly during major bouts of risk aversion. It's no secret the U.S. stock market is having a stinky year. And it's no secret the dollar is following that lead.

Just recently we experienced what I call the triple whammy — a flight out of U.S. stocks, U.S. bonds and the U.S. dollar. This points to the possibility that investors are growing increasingly concerned about a potential collapse of the U.S. financial system. This type of risk bodes ill for the buck because capital would flee ALL U.S. assets.

Scenario #2 — The U.S. dollar rises as the U.S. economy becomes relatively less bad. For much of the last couple years, the U.S. has been the laughingstock among major global economies. And for longer than that the buck has been sinking lower and lower and lower versus the major currencies.

But now analysts, economists and investors are beginning to notice a weakening trend seeping into many developed nations. The secret is already out on the United Kingdom. They're following the path of the U.S.

The commodity dollar countries — Canada, Australia, New Zealand — have all had their scares, too.

And European countries are now on the economic watch list for fear they're at risk of major collapse. And it doesn't look like they'll be getting off that list any time soon.

Bottom line: If the U.S. muddles along while Europe et al start to crater, the dollar can rally as its disadvantage narrows.

Scenario #3 — The U.S. dollar falls on doom and gloom. Of course, it doesn't matter so much what's happening in Europe or anywhere else if it pales in comparison to what's happening in the U.S. This scenario is similar to scenario #1, but to me it implies a LENGTHIER dollar decline.

Which scenario is most likely right now? I'm leaning toward scenario #2, especially in light of what I saw happen this past Thursday.

Best wishes,


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