D-Day for the U.S. Dollar

The Smart Profits Report: Issue #328
Monday, July 10, 2006

D-Day for the U.S. Dollar: As the Fed Gets Back to “Normal,” Why August 8 is Key
By Jim Stanton
Advisory Panelist, Mt. Vernon Research

Do you remember the “triple whammy” of 2001? You should. These three forces combined to form a potent cocktail of market turbulence that set the U.S. back on its heels for a significant time.

We had the brutal bear market, due to an inevitable correction from the heady bullishness in the late 1990s and the fallout from the dotcom crash.
That led to declining consumer confidence and a steady erosion of consumer spending, which stifled economic growth.
And as if that weren’t enough, America then endured the worst terrorist attacks in its history on 9/11.

Amid the upheaval and two subsequent wars in Afghanistan and Iraq, the Federal Reserve took extreme measures and sent the Fed funds interest rate down to the lowest level in decades - 1% on June 25, 2003. A year later, the Fed began to raise again. Two years and 17 straight interest rate hikes later, the base rate now sits at 5.25% - with another 0.25% increase to come on August 8.

What does this mean? Even though the trend started more than five years ago, it still weighs heavily today - and wields a potentially dangerous impact towards a D-Day for the U.S. dollar…

Fed Gets Back to “Normal” - But Dents the Dollar?

Both the rate cuts and increases were necessary to stabilize the economy. And while economists and investors continue to fret about where interest rates are going, the fact is, the Fed has merely brought rates back up to “normal levels.”

That’s why August 8 is a key date…

Fed Chairman Ben Bernanke will raise rates one more time, then stop - a move that will make the value of the dollar much more important.

Take a look at the chart below, showing the dollar’s weekly performance since April 2003. As you can see, the Dollar Index reached a low around 80 in December 2004 - just two points above the 1992 low. 2005 signaled a major reversal, with the dollar rebounding back up to the 92.70 area by November. But it couldn’t sustain its run and the greenback could now be in trouble…

The Dollar's Weekly Performance Since April'03

As you can see, the nine-month slump has resulted in the dollar setting up a reverse head-and-shoulders pattern. Although this is generally a bullish trend, it would have to close above the “neckline” at 92.70 in order to trigger a buy signal.

Right now, that scenario looks like a tall order - and one that could take several weeks or months to occur.

The Dollar is at a Pivotal Point

Let me show you what I mean…

Below is a daily chart of the Dollar Index that shows a regression channel drawn from the highs set in November 2005.

Daily Chart of the Dollar Index in November'05

There are two scenarios here:

Bearish: The low of the right shoulder is 83.60, set in May. At current levels, the index is just two points away from that level and a close below it would violate the head-and-shoulders pattern.

So is there a glimmer of hope? Yes…

Bullish: If the index can close back above the upper channel of the regression line, which is currently around 88, it should propel the index back up to test or break the neckline. At current levels, the index is about three points away from the top of the regression channel.

Fed to Pause in August… Unless Dollar Makes New Lows

From 1992 until the dotcom bubble burst in 2000, the dollar jumped a remarkable 55% against other world currencies before the bear market began. Tax cuts helped reignite the economy and pushed stocks higher, but apart from the added expense of the war and last year’s hurricanes, Congress went back to its old ways of deficit spending and the dollar gave back most of gains it chalked up in the 1990s. So much for a “strong dollar policy.”

Aside from the Japanese yen, most of the world’s most important currencies are at or near long-term highs versus the U.S. Dollar and it now costs more than $0.90 to buy a Canadian dollar.

The U.S. government cannot allow this trend to continue.

The Fed’s Defense Against a Weaker Dollar

While a weaker dollar would help exporters and slow the rapid expansion of the U.S. trade deficit, the negative effects far outweigh the positive ones. Among other things, a weaker dollar usually causes a rise in inflation. In addition, foreign investors, along with their governments, may begin to liquidate their dollar-denominated assets, which in turn, would put pressure on the stock and bond markets.

The Fed’s main defense against a falling dollar (and inflation) is to raise interest rates. As long as the Dollar Index stays above 78, the Fed will probably stop raising rates after its August meeting. But if the dollar makes new lows, higher rates are likely and stocks will suffer.

Good Trading,

Jim Stanton

Today’s Smart Profits Cribsheet

Let the Smart Profits Report broaden your investment knowledge and improve your success rate by adding the important “head-and-shoulders” term to your arsenal. This trading pattern is a key technical tool I use to gauge which direction a security is headed next and whether it’s time to sell. Learn more about it in Smart Profits #291, Head and Shoulders Pattern: A Proven Sell Signal Called Breaking the “Neckline”!

Of course, knowing the right time to sell and having the discipline to do so is arguably the most important - but one of the most difficult - decisions you have to make as an investor. Pick up a few tips from seasoned options trading veteran Steve McDonald in Smart Profits #288, Sell to Close Options: How “Patient” Trading Turned $8,000 into $192,000.