Tuesday, March 11, 2008

A Technical Look at the U.S. Dollar's Decline

Longtime reader/correspondent Cheryl A. suggested it was an appropriate time for an update on the U.S. dollar, and I concur.
To provide you the best available analysis, I asked frequent contributor Harun I. for assistance. His comments--and links to the charts he kindly provided--follow. Just double-click on any link and the chart will open in a new browser window.

Here is Harun's commentary:

When discussing financial or futures/commodity instruments we must determine what it is worth. Looking at price in a vacuum cannot do this. Value must be based on some comparison. Usually this comparison centers on the ability to exchange one commodity for another.
Therefore before I get to a technical analysis of the US dollar I will present charts that will use gold as a proxy for commodities as a constant to establish the purchasing power or relative value of the three largest currency components of the US dollar index, the Euro, Japanese Yen, and the British Pound. These monthly charts will also provide a historical relative performance record.
Dollar-Gold-Ratio
Pound-Gold-Ratio
Euro-Gold-Ratio
Yen-Gold-Ratio
As you can see the largest components of the US dollar index in terms of the ability to purchase gold/commodities, have lost significant value regardless of nominal price readings. It can also be seen that the relative performance is not very different from the US dollar.

From these charts one could arrive at the conclusion that all of these currency’s purchasing power has diminished considerably and show no sign of reversal in the near term.

The first chart of the US dollar index is a long-term view from 1967-present. The centerline of the channel is a linear regression line with the channel line drawn at 2 standard errors from the regression line.
USD Monthly Chart 1
While the top channel line has been touched and even breached in the past. The level of the bottom channel line is currently at about 62. However it must be noted that in its entire history it has never touched the bottom channel line, which is not to say that it is impossible.

The Fibonacci extension lines indicate that price is approaching a move 50% of the length of the last move as measured from the 2001 high to the 2004 low. The numbers that usually matter with this tool are 61.8%, 100%, and the 161.8% extensions. 61.8% is at about 67, 100% about 52, and 161.8% is around 27.

There are no guarantees and anyone who tells you so is not being honest. The 2001 high was a 50 percent retrace of the 1985 top to the 1992 bottom. I will leave it to skeptics of this method to take as many charts in as many different time frames as they choose and they will find that these numbers have a tendency of being hit.

The second monthly chart shows USD with the well-known MACD. MACD is in sell mode but is also indicating an unconfirmed convergence suggesting a change (slowing in this case) in the rate of acceleration of price movement. I emphasize that price has not confirmed this -- convergences/divergences do fail.
USD Monthly Chart 2

Finally for this series the simplest of indicators, the 12-month simple moving average, indicates the trend is down.
USD Monthly Chart 3

The weekly chart has Bollinger Bands and the net percent open interest of commercial traders. Price has penetrated beyond the lower band, which usually is, an indication of continuation. This has to be tempered by the tendency of price to correct or consolidate after closing outside the band. The bands are expanding in opposite directions – this is and indication of good volatility on the breakout.

Commercial traders are net long. Since these traders must be hedging we must conclude that they are protecting short dollar positions from a strengthening dollar. What is interesting is that previous levels of net long positions resulted in normal retracements. The lifting of these net long positions recently produced a mild consolidation.
USD COT (Commitment of Traders)

Finally the daily chart shows a pattern breakdown, which has a downside measuring potential of around 71.95. The red lines and text are Fib retracement numbers that indicate a 50% retracement of this move would end at resistance that once was support. The blue lines and text are Fib projections indicating price has already broken the 61.8 projection but may see consolidation or reaction, as Friday’s bar was a reversal bar. The 100% projection is around 70.

While these numbers may prove accurate, I view them with some skepticism because of a lack of confluence. There are no targets in this time frame that keep repeating (exactly or in approximation). And therein lies the risk.
USD Daily Chart 1

The second daily chart shows a completion of the short-term Fib projection. We’ll have to wait and see if there is a reaction in the days to come.
USD Daily Chart 2

In summary, major global currencies have suffered a significant loss of purchasing power and the primary trend is still down. (emphasis added--CHS) This helps to define the dilemma policy makers are facing. There are apparently no good answers. The US dollars’ primary trend is down, and having broken multi-decade support, we are in uncharted territory. The technical projections are just that – projections, not predictions. MACD is showing a convergence, that if confirmed would shake out weak shorts. Bernanke and company were comfortable with a controlled devaluation of the dollar but intermediate indications (Bollinger bands) are showing an increase in volatility.

Harun's additional comments add a historical context to the dollar's weakness:

First the Founding Fathers wrote into the Constitution of the United States:
Article 1, Section 8: Powers of Congress
To coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights and Measures;
To provide for the Punishment of counterfeiting the Securities and current Coin of the United States;
Then Sir Josiah Stamp had this to say:

"The modern banking system manufactures money out of nothing. The process is perhaps the most astounding piece of sleight of hand that was ever invented. Banking was conceived in inequity and born in sin . Bankers own the earth. Take it away from them but leave them the power to create money, and with a flick of a pen, they will create enough money to buy it back again . Take this great power away from them and all great fortunes like mine will disappear, for then this would be a better and happier world to live in . But if you want to continue to be the slaves of bankers and pay the cost of your own slavery, then let bankers continue to create money and control credit."

--- Sir Josiah Stamp, president of the Bank of England and the second richest man in Britain in the 1920's, speaking at the University of Texas in 1927.

Perhaps the Founding Fathers and Sir Stamp understood the lesson of John Law's and France's misadventures (as summarized on Wikipedia:)
Law exaggerated the wealth of Louisiana with an effective marketing scheme, which led to wild speculation on the shares of the company in 1719. In February 1720 it was valued for a very high future cash flow at 10,000 livres. Shares rose from 500 livres in 1719 to as much as 15,000 livres in the first half of 1720, but by the summer of 1720, there was a sudden decline in confidence, leading to a 97 per cent decline in market capitalization by 1721. Predictably, the 'bubble' burst at the end of 1720, when opponents of the financier attempted en masse to convert their notes into specie. By the end of 1720 Philippe II dismissed Law, who then fled from France."

Just change the language to housing or mortgage derivatives or CDO's, SIV's etc., and we have the nature of what has actually happened -- bankers creating money out of thin air.
But the Constitution forbids this and my fellow Americans have yet to reconcile this. JFK remedied this but as quick as his demise was it swept away. Perhaps that time, once again, is at hand.

Thank you, Cheryl, for the topic suggestion, and Harun for the charts and commentary.

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