The U.S. dollar continues to battle it out valiantly in the currency market trenches. After breaking out decisively to the upside throughout September, the U.S. dollar was sent reeling from the moment the Fed launched Operation Twist at the beginning of October. But after sustaining what looked like a knock out blow just over a week ago from the Greece bailout agreement in the eurozone, the dollar managed to get back on its feet and came back swinging. With the collapse of MF Global and the latest in a long series of setbacks in the European debt crisis both in the past week, the U.S. dollar finds itself with the momentum once again. And it is now at a critical inflection point as we head into the coming week.
The fundamental case for owning the U.S. dollar remains strong. Although the U.S. Federal Reserve has already launched Operation Twist and has indicated that it stands ready to deploy QE3 in the coming months, the forces at work in the global economy may more than offset these dollar-weakening influences. Leading among these is the fact that the primary currency used to measure of the value of the U.S. dollar is the euro. And the profound instabilities that continue to persist in the eurozone region make the U.S. dollar a potentially attractive alternative for two key reasons.
First, the European Central Bank may be forced into its own aggressive monetary easing before its all said and done to rescue the euro currency. New ECB President Mario Draghi has already kicked off a new trend toward policy easing with an unexpected interest rate cut this past week. And looking ahead, it is becoming increasingly possible that perhaps the only way to salvage the euro currency at the end of the day is if the ECB begins massively large scale asset purchases of sovereign debt including Italy and Spain. Thus, Europe may soon find itself easing far more aggressively than the United States in the near future.
Second, suppose the eurozone experiment were to ultimately fail. At present, the euro currency (FXE) trades at a 37% premium over the U.S. dollar, so the potential for a downward adjustment in this exchange rate relationship is possible as long as the crisis drags itself out. And if the euro experiment collapses altogether, institutions worldwide would be clamoring desperately for safety. And the U.S. dollar along with the Japanese yen (FXY) and gold (GLD) are the primary safe haven destinations in times of crisis and extreme stress, with the U.S. dollar leading among these in very short-term time periods.
These factors are more medium-term to long-term in nature. Thus, it is also important to consider what we might expect from the U.S. dollar in the short-term.
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Examining the U.S. dollar as measured by the PowerShares DB US Dollar Index Bullish ETF (UUP), we see that the greenback is once again at a crossroads. It closed Friday right within its resistance/support line in the range of $21.70 to $22.00. Along the way, it managed to reclaim its 200-day moving average (red line in the chart above) and is currently working to also fight its way back above its 50-day moving average. A decisive breakout above these levels would be decidedly bullish for the U.S. dollar.
Conversely, it is also possible that the U.S. dollar could fail at current levels, which would suggest the potential for another prolonged period of U.S. dollar weakness. However, the U.S. dollar has established a well-tested support range between $20.80 and $21.20 on the UUP. Overall, the greenback has fallen to these levels six times since early May 2011 only to bounce back in each instance. Thus, if we do see the U.S. dollar shift lower from current levels, the potential downside is clearly defined at -2% to -4% before a further break below this support range would trigger a sell signal from a trading perspective.
Given these opposing forces, the potential upside for the U.S. dollar appears to outweigh the potential downside at the current juncture. Supporting this notion further is the recent shift in relative strength and momentum. When the U.S. dollar was last at these levels in mid October, its Relative Strength Index was below 50 and trending lower and momentum readings were trending sharply to the downside. But today, the RSI has bounced back to the 50 level while momentum indicators also appear to have bottomed and are now trending higher. These are additional bullish signals for the dollar looking ahead to the coming weeks.
Of course, currency trading can be notoriously unpredictable and volatile. And any movements in the U.S. dollar will be at the mercy of the still unpredictable events unfolding in the eurozone. As a result, any allocations to the U.S. dollar should represent only a limited allocation in an overall portfolio and undertaken with close attention to critical price points along the way.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.
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