THE U.S. DOLLAR! September 18, 2009

Being Street Smart

Sy Harding

THE U.S. DOLLAR!  September 18, 2009.

The U.S. dollar fell to a 12-month low against most major currencies on Thursday, with by far the majority of currency traders believing it will continue its freefall. And on the fundamentals, the dollar doesn’t seem to have much going for it to reverse the trend.

Global interest rates are at historic lows, but few as low as the record low Fed Funds rate of 0 to 0.25% in the U.S. The European Central Bank’s key interest rate is also at a record low, but at 1%. That creates lucrative opportunities for speculators to borrow dollars at low cost, and invest the proceeds in higher-yielding assets elsewhere.

Further pressure on the dollar is coming from major trading partners of the U.S. They receive inflow from their exports in dollars, and if those dollars are declining in value, it tempts them to sell dollars and buy other currencies.

Meanwhile, with global commodities priced in U.S. dollars, still other countries, particularly oil-producing countries, are unhappy with the dollar being the world’s primary currency, as they are also being paid with a currency that is declining in value.

So pressure that began from China, Russia and Venezuela to have the dollar replaced as the global currency by a balanced ‘basket’ of various currencies, is spreading. A few weeks ago even the United Nations Conference on Trade and Development called for replacing the dollar with a ‘global’ currency.

There is also little incentive for the U.S. to intervene in currency markets to support the dollar (as global central banks often do to support their currencies when necessary). The U.S. is struggling to come out of a severe recession, and anything that makes foreign imports more expensive for U.S. consumers, and U.S. exports less expensive for consumers in foreign countries, is a boost for the U.S. economic recovery.

So the U.S., as it has done for the last ten years, talks a good talk about how it supports a strong dollar, but does nothing about the situation.

Fed chairman Bernanke, perhaps inadvertently, prompted last week’s further plunge in the dollar when he stated that the U.S. recession has probably ended technically, but that the recovery will be slow with potential pitfalls along the way. That was taken by currency traders as an indication that the record low interest rates in the U.S. will probably be in place for quite some time yet, encouraging currency traders to increase their short-sales of the dollar.

But be careful about jumping in against the dollar at this point.

As with all market moves, after its big decline the easy money to be made by betting against the dollar has become the talk of the financial media, with “Sell the dollar, buy the Euro,” the most popular advice from analysts.

But with big profits having already been made by the smart money that entered near the top in July, and the trade being belatedly popularized in the media, it’s more likely time to be watching for an upside reversal.

Here are two reasons why I think an upside reversal may be near for the dollar.

Investor sentiment against the dollar has become extremely one-sided, which must have professional currency traders on the edge of their seats ready to take profits. The Bloomberg Dollar Bullish Sentiment Index has fallen to 30.8, from a high of 68.86 a year ago, its lowest level since it fell to 30.3 in March, 2008.

It’s of interest to note that March, 2008 marked the bottom of the dollar’s multi-year plunge from its high in 2004. From that low in March, 2008 the dollar rallied 25% to its peak in March of this year. And here is sentiment against the dollar back to that extreme of bearishness.

My second reason to think an upside reversal in the dollar may be near is that in its decline, as I show in a chart on my daily markets blog, the dollar has now become very oversold beneath its 30-week moving average.

The long-term history is that its 30-week m.a. acts as a powerful magnet on the dollar. Any time in the past that the dollar was in a bull market and became overbought (over-extended) above the m.a., it soon pulled back at least to retest the support at the m.a., even if it was then to resume its bull market.

More important to the current situation is that any time in the past that the dollar was in a serious decline and became oversold beneath its 30-week m.a., it soon began to rally back up at least to the m.a., even if it was destined to then resume its decline.

Given the current high level of short-selling of the dollar, any upside reversal that begins would likely result in short-sellers being forced to the buy side to close out positions to an unusual degree, creating a fast spike-up move.

So those are my reasons for believing this is not a good time to take new positions in this so-called “easy money” trade.

Additionally, with other markets, including gold and the stock market, so closely linked to the direction of the dollar, keeping a close watch on the dollar for a possible reversal may well be more important than watching those other markets themselves.

Sy Harding is president of Asset Management Research Corp, publishers of the financial website www.StreetSmartReport.com, and the free daily market blog, www.syhardingblog.com.