Dollar Update - How low will it go?

12/18 UPDATE:
1st Target $77.81 met! We bounced off of a low yesterday of $77.69 and are seeing strength. This provides an early cue to trim or hedge commodity related positions. See updated chart at http://screencast.com/t/VgLFKk1AN9v

Implications? Commodity related positions (Gold, fertilizer and oil stocks) will likely deteriorate with Dollar strength. ***************************************************************************************

The object of technical analysis is not to simply to forecast but to identify attractive risk/reward opportunities. In previous posts we highlighted the Dollars peak and its subsequent slice through major support. In the process it flashed a textbook signal - a Head and Shoulders pattern. This signaled an intermediate trend change.

If you been reading and have taken advantage of this signal with appropriate currency pairs or going long commodities you should now be wondering how far will the slide last? More appropriately you should be asking at what point does the Dollar short cease be an attractive risk/reward? The chart below provides some helpful clues.

There is a convergence of indicators pointing to a near term target of $76-78 for the US Dollar index.

• Head and Shoulders: First we see a clear representation of a Head and Shoulders pattern expressed on the US Dollar Index. A rule of thumb for H&S patterns is the height above the neckline is often matched by an equal depth below the neckline. Using a Fibonacci tool this implies a target of $77.81
  
• Moving Average: The 200 DMA is nearing $77

• Support levels: We see prior support coming in at $76. A prior resistance level at $80 was never tested and probably won't be much of a factor.

Alternate indicators: The RSI and Stochastics (highlighted in red) are entering oversold values. Simply reaching these values is not an automatic signal to cover (or buy long), but you should be paying close attention here.

The MACD is still very much bearish and persisting in that trend, but should be watched closely as well. This indicator will most likely provide the earliest signal for a rebound. A great tutorial on this important tool can be found here. I will be looking for an early divergence in the histogram followed by a crossover of the moving averages.


Why is the US Dollar so important? Take a look at the inverse relationship of the US Dollar and Commodities. Commodity related stocks have been coming to life, notably Gold and miners (GG, ABX) and to lesser extent Fertilizer stocks (CF, MOS, POT) and still lesser oil. Their performance is magnified by the action in the dollar.

In the Macro economic picture we experienced violent deleveraging. We continue to experience deflation as a result of credit contraction. There is a massive effort to offset the destructive effects of these by the Fed. The result has been a sharp increase in money supply -see "Bernanke's game plan" in the side bar. This new money is still being hoarded by banks seeking to shore up their balance sheets, but eventually it will make it's way into the market.

Long term it is clear the FED views a depreciation of the US dollar and even a sharp devaluation as an attractive monetary policy. Europe, Latin America and most notable China have all began to loosen (depreciate) monetary policy in a tactic know a "Beggar thy Neighbor" economics. Investors now should be worried about the value of the dollar going forward. A short term rebound of the dollar as indicated in the first chart may provide an second opportunity to enter commodity related issues at a discount or make follow-up buys.

Not all commodities are created equal. While commodities in general will "benefit" from a depreciating Dollar the world economy is deteriorating. Demand destruction remains a factor in energy related commodities, less so in Agricultural, and least so in precious metals. Gold in particular is faring nicely despite deleveraging, deflation and demand destruction (jewelry). The main reason is monetary uncertainty creates demand in Gold and to a lesser extent Silver.

It's time to pay attention.

Dollar Watch

In a previous post I noted coorelation between commodity deleveraging and it's affect on the Dollar and Stocks - link . With that theory as a basis I believe the action in the dollar will have implications in commodities, namely a weakening dollar should accompany stronger commodity prices. The descent of commodities (in general) seems to have stalled although no tradable pattern has emerged yet. However the short term action in the dollar is flashing sell signals.

Dec Dollar futures, DZX8 as a proxy for the Dollar:

Ag commodities look poised to fare best in this scenario (hat tip to Tim). The pattern is not fully formed nor confirmed by volume, but promising and one to watch nonetheless.

I would like to see a reversal in the commodities index as well.

To summarize, I'm looking for the dollar to lead commodities. The dollar may be topping. I think AG commodities may be a better play than say oil or precious metals. The latter still have a bearish look to them.

Bullish hopes abound - is it a trap?

The four major indexes are flashing bullish signs right now. We successfully tested the bottom last week with a hard bounce. The next day's profit taking resulted in a higher low - not unexpected and still positive.


Let's review some facts affecting biases. Selling in the past month has been violently amplified by deleveraging across all asset classes. Deleveraging cares not for valuation, but survival. We know in every case market plunges produced powerful rebounds that revert to or near the mean. We are dramatically off significant moving averages. However, aside from these developments alternate indicators cannot rule out the potential for more downside.





The dramatic fall in commodities seems to have caused a rise of the US Dollar and a fall in stocks. This is most likely due to the unwinding of leveraged bets back into cash, i.e Dollars.



The chart below indicates the Dollar's rise may not be over implying the potential for more pain in asset classes. I say this tenatively because I believe the Dollars rise is an "effect" not the "cause". The tail doesn't wag the dog, but the chart should nonetheless considered in our decision making.





So is it safe to go back into the pool? Maybe. I sense we're close if not there. The Hedge fund redemption window closed this Saturday. This could signal an end to deleveraging. I'll be watchting the performance of commodities for clues. But let's not get lulled into thinking all lights are green. They are not.

The Dollar peak

The dollar has stopped it's meteoric rise. It's important to understand that's it's strength HAS NOT come from strong economic fundamentals. The dollars strength can be attributed to a few things:

Deleveraging

Currency traders have had two favorite currencies to borrow from - the Yen and the Dollar. The Yen offered near zero interest while cross currencies from Australia and New Zealand were paying interest rates from 8-10% while appreciating in value. Free money! Until it wasn't. As these leveraged trades unwind the money gets repatriated to the country of origin to pay back what was borrowed. Both the Yen and the Dollar have seen rapid appreciation from the unwind of these trades while the investments (AUD, NZD, Commodities,etc) these currencies funded sold off ...massively

Flight to safety

As the Credit Crisis spread to Europe the darling Euro's potential as an alternate to the dollar has been questioned. Certain European nations are now asking themselves if they should bail out other members who engaged in reckless lending just to support a unified currency. That question remains. Many speculate that the Euro could be abandoned as a result. Those who sought safety in an appreciating Euro put that money back into the good old dollar.

Deflation

Lets not forget deflation. The destruction of credit-money now taking place is affecting money supply despite the Feds best efforts to keep the balloon inflated. The rapidity of the Dollars appreciation concurrent with the fall in equities is consistent with a nasty deflationary spiral of deleveraging and credit contraction.

But the important thing to realize is:

1) The Dollar's rise has abated.

2) It's current level is likely to be temporary.

3) Our economy is not strengthening, it's weakening.

4) Fed bailout's, stimulus and liquidity measures create inflationary pressure.

Notice in both charts the carnage began in July. Commodity and currency markets show a similar trend. This is indication that borrowed bets on commodities, equities and cross currencies started to deteriorate and positions were liquidated causing traders to buy back the currency they borrowed against - the Yen and Dollar.

All commodities should "benefit", but especially Oil related equities.