THE DOLLAR IS HEADED DOWN / BARRON´S MAGAZINE ( A MUST READ )

Up and Down Wall Street

FRIDAY, SEPTEMBER 24, 2010

The Dollar Is Headed Lower

By RANDALL W. FORSYTH

Charts, the Fed point to weaker greenback, higher gold.


THE DOLLAR'S TREND NOW is unequivocally lower. And that's apparent whether you look at fundamental factors or the technical picture on the charts.


Since the Federal Reserve's policy-setting Open Market Committee Tuesday signaled its intent to do whatever it takes to stave off deflation, the dollar broken down through support on the charts.


That is consistent with the argument made here last week that, with short-term interest rates virtually at zero, central banks' attempts at monetary stimulus would mainly be transmitted through the currency markets. ("Central Banks Embrace Risky Currency Gambit," Sept. 17) And, indeed, that's what seems to be happening.


From the technical perspective, the U.S. Dollar Index (DXY) has had a major breakdown through support levels on price charts. George Davis, chief technical analyst at RBC Capital Markets, notes the completion of a classic head-and-shoulders pattern, which he says "paints a very ominous profile for [the dollar] for the next 10-12 months.


Richard Ross, Auerbach Grayson's technical maven, also points to the same head-and-shoulders formation and looks for the Dollar Index to finish a round-trip to last December's lows. That would translate into a drop of about 7.5% from here after the 11% decline in Dollar Index since its midyear peak.


(As with so many instruments and indexes formerly not readily available to individual investors, exchange-traded funds lets you play along at home if you're so inclined. The PowerShares DB US Dollar Index Bullish ETF (UUP) tracks the DXY, while the PowerShares DB US Dollar Index Bearish ETF (UDN) moves up as the DXY moves down.)


The Dollar Index consists of a basket of six major currencies but is dominated by the euro. (The others are the Japanese yen, the British pound, the Canadian dollar, the Swedish krona and the Swiss franc. The index was created in 1973 and has only been changed to reflect the introduction of the euro in 1999.)


The breakdown in the Dollar Index has been paralleled by the upside breakout of the euro, hitting $1.34 earlier in the week. Moreover, the high-profile intervention by the Bank of Japan last week to bring down the soaring yen merely put the dollar's exchange rate versus the yen up to the top of its trend—which remains in a clear descent, RBC's Davis observes.


The Fed and the BOJ both are intent upon expanding domestic liquidity and cheapening their currencies—implicitly in the case of the former, explicitly in the latter.


To review the basics of open-market operations, when a central bank purchases assets of any kind—Treasury notes, foreign currencies, dicey loans—it creates liquidity out of thin air. It writes a check against itself to the seller of that asset, which has cash in their account to spend. In the case of the BOJ, it typically had offset, or "sterilized," purchases of currencies with sales of bonds. Not this time, leaving an extra ¥2 trillion sloshing around the Japanese financial system, which ought to cheapen the yen.


While the Fed has indicated readiness and willingness to expand its balance sheet and the BOJ has shown its ability to do so, that leaves only one central bank of the so-called G3 left out—the European Central Bank. Instead, the ECB has seen the euro rally sharply from its low around $1.16 last June.


According to John R. Taylor Jr., chairman and chief investment officer of FX Concepts, the euro's rebound has been the result of the rescue of the tottering sovereign debtors of the eurozone, notably Greece, as the spring crisis subsided. But the recovery in the euro is the result of the successful government bond auctions recently—at interest rates that will choke off growth. (Hat tip to ZeroHedge.com for posting Taylor's note.)


The high interest rates paid by "the stricken debtor nations" of Portugal, Ireland, Italy, Greece and Spain "will force them into defaults," according to Taylor. The soaring euro will exacerbate deflation as cheap imports hit local business as well as throw a spanner into the German export machine.


That's already apparent in purchasing-manager data from Europe. The overall eurozone PMI fell more than expected in September, to 53.8 from 56.2 in August. The deterioration in Germany was especially acute; its PMI plunged to 54.8 from 58.4. Remember than Germany was a beneficiary of the sovereign debt crisis, realizing growth of nearly 9% in the second quarter because of the amphetamine-like boost to exports from the resulting collapse in the euro.


All that boost is fading, which would make the euro vulnerable. But with the Fed and the BOJ ahead in the race to bottom for their currencies, the ECB can't afford to fall far behind. Not to worry on that score, writes Taylor. "When the next recession is in full boom by the start of next year, at the very latest, the dollar will rally as the shortage of dollars impacts global business."


That was the pattern in late 2008 and early 2009, when massive deleveraging created a global demand for dollars to close out positions; that meant repaying borrowings, which in effect meant covering dollar short positions.


For the near term, however, the dollar's course appears lower. By contrast, currencies in economies buoyed by rising commodity prices and with central banks moving to tighten, not loosen, policies should be winners. In that category are the Canadian and Australian dollars, along with the Brazilian real. (ETFs that track those currencies are CurrencyShares Canadian Dollar Trust (FXC), CurrencyShares Australian Dollar Trust (FXA ) and the WisdomTree Brazilian Real Fund (BZF.)


But the message remains is that major central banks are working to varying degrees to weaken their currencies. The thing is that they all can't devalue to gain a competitive advantage.


This conundrum that not all currencies can devalue against each other has pushed gold—which is increasingly viewed as a currency instead of a commodity—at a record. It has pulled back from $1300 mark, which may reflect activity in about-to-expire October call options with that nice, round strike price.


An "ugly contest" is under way among the world's currencies, with the dollar a likely winner of that dubious distinction.


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