Tuesday, September 2, 2008

Currencies - Disaster or Opportunity?

As we enter September, we seem to be beginning a new chapter for the U.S. dollar. Some currencies are crashing at record rates! The U.S. dollar just recorded its best monthly advance since October 1992 largely because sentiment on the U.S economy improved when data showed the U.S. should have much more stable growth than the rest of the world.

A Commerce Department report showed inflation rising at 4.5% in July -- the highest rate since February 1991. The revision of the 2nd quarter gross domestic product (GDP) grew at a whopping 3.3% from the initial estimate of 1.9%, helping the U.S. dollar maintain the strength of its recent rally.

On the flip side, we are seeing the global economy slowing down. Antonio Sousa at Forex Capital Markets said, "Recent economic data points towards a weakening of real GDP growth in the Eurozone economy and a more accommodative monetary policy could be needed to prevent the region from falling into a recession."

The Euro declined by about 8% against the U.S. dollar -- the worst monthly loss since its launch in 1999. The Australian dollar fell nearly 9% in August, its worst month since February 1989 on expectations of narrowing interest rate differentials between the United States and Australia.

Although economists were expecting a 0.7 percent expansion, data showed the Canadian economy was close to a recession in the second quarter, growing at 0.3 percent.

How can we profit from the dollar's current up-trend? If you're in the U.S., you just sit tight because you're currently on the winning team. The green paper you keep in your wallet are stock certificates of the U.S. and the stock has been gaining strength. You should be happy because whether you realize it or not, the stock you've maintained a long-term position in (the greenback) has lost about 40% of its value since early 2002.

Will the Dollar Rally Last?

The questions are: How long will the strength in the U.S. dollar last? What will you do if the recent up-trend in the U.S. dollar ends and the long-term decline resumes?

I'll suggest how to avoid losses in the U.S. dollar when the opposite inevitably happens. It's impossible to know exactly how long this will last but what we CAN do is get an understanding of the playing field so we understand how to hedge when the tide changes.

First of all, we know that commodities are in a very long-term up-trend, but the intermediate trend is certainly downward. Since most commodities are priced in U.S. dollars, commodities and the U.S. dollar have an inverse relationship which explains the dollar getting whacked since late 2001 - early 2002 as the price of commodities like crude oil and gold have advanced.

The next thing you need to know is when commodities are advancing, they tend to have massive explosions to the upside (as we recently witnessed). Conversely, when commodities correct in price, they tend to correct for a long time. (You may recall in summer of 2006 when oil made it up to about $80.00/barrel and corrected. It took about a year to make it back to that price level!).

Whatever the trend is in commodities (up or down), it's strong. Think of commodities like a gigantic truck doing 100 miles per hour and then slamming on the breaks. It will continue skidding for a long time before stopping.

While we have a sharp correction in commodity prices underway, the odds are in favor of the long-term up-trend eventually resuming. Similarly, (or inversely) the U.S. dollar is showing intermediate strength these days, as U.S. consumer confidence hit a five-month high in August, adding to optimism on the greenback. But the odds are good that the current optimism will return to long-term pessimism.

How to Profit When the Dollar Dives

This article may be a bit premature for the time being, but better early than late. First, I will give you the security and then I will tell you when to use it. The Exchange Traded Fund (ETF) that tracks the inverse of the U.S. dollar's performance is PowerShares DB US Dollar Index Bearish (UDN). Below is the Fund Summary:


The investment seeks to track the price and yield performance, before fees and expenses, of the Deutsche Bank Short US Dollar Futures index. The index is comprised solely of short futures contracts. The futures contract is designed to replicate the performance of being short the US Dollar against the Euro, Japanese Yen, British Pound, Canadian Dollar, Swedish Krona and Swiss Franc.

I don't think this is the perfect time to get in, but I do think we are getting close to it. Here's how you should time it:

You may or may not be familiar with a momentum indicator called the "Relative Strength Index" (a. k. a. the "RSI"). I won't get into the mechanics of how it is calculated, but I'll tell you how to use the RSI line to find a good entry point in UDN. Here's a link to the US Dollar Index chart http://www.fxstreet.com/rates-charts/usdollar-index/.

You will see at the bottom, that the RSI is plotted. You can see the last three times the RSI moved well above the 70 mark and reversed lower, the U.S. dollar was at a high point in the long-term down trend and it immediately continued its declining trend. You will also notice that the RSI moved further into the "overbought territory" (over 70) than anywhere else on the chart.

Now here's the part that really needs some explaining. The RSI is good at calling tops in a down-trend or bottoms in an up-trend. (You wouldn't use it to call a top in an up-trend or a bottom in a down-trend unless other things are in place that I won't get into here).
The top (within a down-trend) is not officially called until the RSI reverses from above 70 to below 70. Don't think just because the RSI is above 70 that it is a good time to get bearish on the U.S. dollar.

You may notice the RSI has, in fact, reversed back below 70. But this time I think it's a fake out and here's why:-

When we see such a sharp advance in the security (in this case, the U.S. dollar) it's best not to act on the first signal (the one we are seeing now). Chances are we will see another move in the RSI back above 70, and then the second reversal back below the 70 line and THAT is when I suggest putting at least 30% - 50% of your available cash in UDN.

Why "at least 30% - 50%" and not 100%? Because it's a hedge and not really a trade. The idea is to soften the blow of a decline in the U.S. dollar. Currencies are volatile, and if you have cash saved that you plan on saving for another year, you may consider putting all of it in UDN. If you view it as a trade, however, you may get in and emotionally exit it at a lower price.

Of course you can decide to put 50% or 100% of your available cash into the ETF. But for some reason I have a feeling many people will view this as a trade and not a hedge. I think that because if you don't hedge the dollar, most people never really comprehend that their money is losing value or gaining value. They just think the dollar is the dollar.
But if you really think about it anyone who hedged the U.S. dollar since UDN launched in 2007 may consider themselves up 20% (since June anyway). Would you have been up 20% or did you merely avoid a 20% decline in the dollar?

So that's the way to hedge against a decline in the US Dollar. Good luck!