The front page of the Money and Investing section of the Wall Street Journal had a special headline on October 19: “Dissecting the Declining Dollar.”
After acknowledging that the dollar could be undervalued based on fundamentals, the Journal then states “Whatever the dollar’s true value, the trends that have punished it this year are still in place, suggesting it has further to fall. U.S. interest rates remain low, government borrowing is high and the economy is expected to remain weak.”
IS IT A ONE-WAY TRADE?
It seems that no asset in recent memory has been as hated as much as the U.S. dollar. Meanwhile, the euro—which has serious structural problems of its own—can seem to do no wrong. While we understand the bearish case against the dollar, we feel that the market has mispriced the euro in response.
BOND BETS
In perhaps the greatest contrarian signal we’ve seen to date concerning the dollar, Barron’s reported that several sovereign borrowers – including Germany and Spain – are denominating their new bond issues in U.S. dollars (See “Happy Hour in the Bond Market,” September 14, 2009). The motivation appears to be currency speculation — in this case, Germany and Spain are betting that the dollar will fall against the euro, thus making their sovereign debts cheaper to pay back.
BE CONTRARIAN
Treasuries and central banks tend to be horrible market timers. Let’s not forget that many sold their gold holdings during the late 1990s and early 2000s — right before the “barbarous relic” went on a multi-year bull run that saw it more than triple in value. Are they making the same mistake again by “selling” the greenback? Only time will tell, but we are comfortable being on the opposite side of the trade.
A TOP?
Our recommendation is to short the euro. Many times the best tool for forex trading is “dead reckoning”, a method used by sailors to determine their position from observations of other fixed structures. In the case of the euro we’ve chosen the Dollar Index and the Aussie dollar as our dead reckoning points.
When looking at the Dollar Index we see a possible turn in the dollar, with the Index creating a descending wedge. Given the action last week, we may be starting to see confirmation of a rally. The other currency worth observing is the Aussie dollar—a commodity currency—which has enjoyed a significant rise against the dollar. It, like the euro, has recently broken support, falling below 0.8950.
THE TRADE: SHORT THE EURO
The euro’s recent fall to 1.4700 suggests that the currency may finally be breaking down. We recommend shorting the euro using the front-month contract. Start with a small position now, and add to your position on rallies of .0035 or more. (Investors without futures accounts can use the Double Short Euro ETN—ticker: DRR—as a viable alternative.) Use reasonable stop losses for your level of risk tolerance; we hesitate to give hard stops given the volatile nature of this market. If you get stopped out, don’t worry. We see this move having a time horizon of six to twelve months and possibly longer, so there should be ample opportunities to re-enter the trade on corrections.