Contrarian's Delight: A Dollar Rally
By Aaron L. Task
Managing Editor -- RealMoney
11/26/2004 7:01 AM EST
In the "catch a falling knife/step in front of a moving train" category, consider a bullish bet on the dollar after its latest schmeissing.
As a longtime, long-term dollar bear, I'm keenly aware of secular forces weighing on the currency, namely the widening U.S. current account and budget deficits (aka "the twins").
With the caveat that the long-term fundamentals point toward continued weakness in the dollar -- barring an abrupt about-face by U.S. policymakers --
there's good potential for a countercyclical move in the coming weeks.
"We're really in the midst of a one-way market and one-way markets don't last indefinitely," said David Gilmore, partner at Foreign Exchange Analytics in Essex, Conn. "I'm sure everyone has told you convincingly why the dollar will weaken ... and when 'everyone' says the same thing, usually the opposite occurs."
Certainly, the "sell the dollar" bandwagon has gotten very crowded. According to Bloomberg, currency traders and strategists are "more bearish on the dollar than at any time in the past 18 months."
Meanwhile, the financial press has jumped on board with hair-raising stories about the dollar's demise -- arguably a good contrarian indicator.
As of last Friday, futures traders had the highest net number of bearish bets on the dollar vs. the yen since February, according to the Commodity Futures Trading Commission. Notably, the Dollar Index, which measures the greenback's value vs. a basket of major currencies, hit a near-term low in mid-February and then embarked on a three-month rally.
On Wednesday, the Dollar Index traded at its lowest level since August 1995 as the euro hit its seventh record high of the month at $1.3178 and the greenback slid to a new 4 1/2-year low vs. the yen and a nine-year low vs. the Swiss franc.
As illustrated above, the Dollar Index is at technical support at a trend line connecting to its January and February lows. "These patterns are considered to be bottoming/reversal patterns suggesting an upside resolution," wrote David Solin, partner at Foreign Exchange Analytics. "When the reversal higher does come, it is likely to be initially sharp and then settle into a month or so of wide-ranging [trading] ."
Leery of the falling knife, Solin recommended waiting for a close above the index's technical "ceiling" around 83.50 before making a bullish bet. (Individuals need a margin account to trade currencies; check with your broker or firms that specialize in foreign exchange such as everbank.com, forEx.com and Oanda.com.)
Another technical sign the dollar might be close to bottoming is the recent action in gold and related stocks. The metal has rallied sharply since its Sept. 8 close of $396 per ounce, but was stymied this week at $350 per ounce, a potential sign of a near-term peak.
Meanwhile, the Amex Gold Bugs Index "experienced, what appears to be, a failed breakout" earlier this month and "did not confirm the bull market high in the metal itself, since the shares peaked earlier in the year," observed Martin Pring, veteran technician and editor of The InterMarket Review.
Given gold's strong inverse correlation to the dollar, such action could be a harbinger of near-term strength in the currency, something Pring forecasts, and/or a more aggressive anti-inflation stance by the Federal Reserve.
Regarding the Fed: I agree wholeheartedly with Peter Eavis that Alan Greenspan's policies contributed mightily to the dollar's weakness, which has been ongoing since mid-2001 (even if some are only now awakening to it). But I take a slightly different view on the significance of Greenspan's speech last Friday.
In sum, I think Greenspan was trying to send a message to the White House that if fiscal policy isn't adjusted in a dollar-friendly way, the Fed will tighten more aggressively than it might otherwise have done. By publicly acknowledging the possibility of a dollar crisis, Greenspan is now more likely to do something about it, even if he (gasp) bucks the Bush administration in the process.
Note: There's more than one "lame duck" in this equation and Greenspan has only until January 2006 to cement his legacy, which he won't want "spoiled" by a dollar disaster.
Perhaps the biggest challenge to a dollar rebound is the lack of a catalyst, given the market has "turned a blind eye to cyclical fundamentals" -- the U.S. economy's strength vs. Europe's and/or Japan's -- and is "focused exclusively on structural issues" of the twin deficits, according to Gilmore.
Furthermore, the calendar provides incentive for hedge fund managers to continue pressing dollar shorts before year-end, notes Marc Chandler, partner of Terra Capital Partners, a consultancy.
Next Friday's U.S. payroll report is one event that could spur a dollar rally, and intervention by the Bank of Japan (BOJ) remains a threat, notwithstanding midweek comments to the contrary by Tsutomu Takebe, secretary-general of Japan's ruling Liberal Democratic Party.
The euro's relatively sharper moves vs. the dollar compared with the yen's reflect that currency levels are "approaching the pain threshold of the BOJ, but not the European Central Bank," according to Chandler. "That's helping flex speculative attention away from the yen" and toward the euro.
But Ashraf Laidi, chief currency analyst at MG Financial Group, suggested Wednesday that the European Central Bank (ECB) "will have to act in the event that the euro nears the $1.35 level."
Because of 2.4% inflation in the eurozone, the ECB has been reluctant to ease monetary policy, contributing to the euro's strength vs. the dollar despite Fed tightening.
"But with Eurozone growth projections being downgraded to as low as 1.7% in 2005 from 2.0% in 2004, an accumulated strengthening in the currency will run counter to the strengthening of the overall economy," Laidi wrote. (Pundits looking for signs of 'stagflation' ought to consider Europe, where inflation remains pesky while growth lags the U.S.)
Finally, for all the hand-wringing over the potential for Chinese revaluation, they are "only talking about a 3-5% widening of the band," Gilmore noted. "The change is relatively small [and] markets are overstating the importance of first liberalization."
In keeping with the contrarian theme of this article, don't be surprised if the initial round of China's revaluation (if and when it occurs) results in relative strength in the dollar, be it due to a 'sell the news' reaction and/or a more intent focus on China's uncertain banking system.
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