Wednesday, November 25, 2009

U.S. Dollar Index Heads Decisively Lower - Could this Turn Ugly?

Today the U.S. Dollar Index (DXY) hit its lowest point in the year of 74.269. For some days the DXY was holding around the 75 level and most of the market was expecting a counter trend rally upwards with a break above the 50-day moving average of 75.90. Instead the DXY collapsed much further (see chart 1).
Looking at Chart 2 we can see that the Index bottomed out in the middle of last year, trading in the 71 -72 range from March'08 -July'08. Once the financial crisis hit the dollar index started rallying because of the flight-to-safety trade. Ever since March'09 when the Fed announced its quantitative easing. the index has been reversing course. Today having broken its short term trading support of 75, there is little in the way of resistance until 72. Beyond 72 its just free-fall with no technical support whatsoever.

Chart 1: Short-Term U.S. Dollar Index Snapshot

Chart 2: Longer-Term U.S. Dollar Index Snapshot

David Rosenberg of Gluskin Sheff had some pertinent thoughts on how quickly this downward move in the DXY could turn ugly:
Considering how crowded the bear-dollar-trade has been, it is remarkable and a testament to its headwinds that we never got much of a counter-trend bounce [in the DXY]. The question going forward is the extent to which the U.S. dollar’s descent can remain orderly, especially when half the country’s marketable bonds are held abroad; deficits are set to exceed $1 trillion annually as far as the eye can see; and central banks are looking for diversification into either hard assets or hard asset proxies.
It will be interesting to see how this plays out because it is always calmest before the storm and quite often serious hiccups in financial markets stem from instability in the FX market (the failed Louvre Accord in 1987 and the Asian FX crisis in 1998 come to mind right away). So far, there has been no leakage from the dollar’s decline into the Treasury market, where bidding at the auctions have been healthy and the 10-year yield sitting just above 3.3%. But as Peter Gibson told us in a presentation on Monday, the Treasury market holds the key (as it did back in 1987 if you recall – and the summer of 2007 too!).
But by hinting in the FOMC minutes that it could take “five or six years” for the U.S. economy to recover, and the economy will remain gripped with excess capacity in the labour market, and at least one Fed official sees deflation risk out to 2012, FX investors have clearly treated the document as a green light for the dollar-carry-trade to persist to perpetuity. The fact that the ranges in the Fed forecasts remain so wide, whether it be for real GDP growth, unemployment or inflation shows just how uncertain the macroeconomic outlook is. For investors who do not like to be characterized as gunslingers, this is not an environment to be adding substantially more risk to the portfolio at this time.
We concur.

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