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Every Trader and Investor Should Be Watching the Dollar


Corrections in other markets may cause a retreat to safety.

A wide set of markets currently seem to be at a cusp, and the direction they go from here might require investors to take a radically different approach to protecting their wealth. Currencies, and particularly the US dollar, may become much more attractive to hold, while speculation in stocks and many commodities may turn risky and become far less rewarding for the investor. Similarly, the trader might consider making use of futures contracts based on the US dollar or the euro (in an approximately inverse relationship to the dollar), as well as long and short dollar ETFs such as those managed by PowerShares (PowerShares Dollar Index Bullish ETF (NYSEARCA:UUP) and PowerShares US Dollar Index Bearish ETF (NYSEARCA:UDN)).

The case that changes are approaching is supported both by fundamental conditions in the economy and by our technical analysis of the charts. In the economy, several factors now coincide that should produce a deflationary effect on currencies generally. For example:
  • The European zone is experiencing a recession, and some peripheral European countries are clearly in a depression. Consumer demand and the need for raw materials in that region have declined. Meanwhile, "austerity" policies have meant a withdrawal of economic stimulus with predictable effects on consumer spending.
  • China is facing limits on the amount of monetary stimulus it can engage in without causing inflationary problems domestically. Thus, there is reduced demand for raw materials, particularly those used in construction, which has contributed to declines in several commodity prices. For example, see our recent articles charting the decline in copper prices.
  • Reduced demand for resources means less export by countries such as Brazil, Russia, India, China, and South Africa (the "BRICS" nations) and correspondingly reduced consumer and government spending within those countries.
  • In the United States, indicators are mixed. There certainly have been some bright spots in economic news this year, but the whole picture is not one of an economy preparing for a growth surge. Corporate profits are starting to subside again, and it is now commonly acknowledged that the multi-year rally in stock prices has been driven largely by Federal Reserve actions and the widespread belief that those actions will continue as long as they are needed.
With interest rates being kept at levels so low they would once have been unbelievable, and with many commodity prices starting to falter, stocks are now the only choice for investors seeking returns similar to what they are accustomed to. Thus, nearly everybody who is in the market is currently long stocks, elevating stock prices far beyond what could be justified by earnings alone.

Ask yourself, if stocks were to experience a substantial correction for any reason, where would investors then choose to put their wealth? Similarly, what if the Fed were to withdraw its support of banks' speculation in stocks? What if the Fed or the market itself were to raise interest rates by just a little, thereby increasing the drag on the economy? What if some other "black swan" event occurred that disrupted a substantial part of the domestic or global economy?

Each of these scenarios is credible, and each would probably result in a great deal of wealth retreating out of traded markets and being redeployed in cash or instruments closely correlated with cash. In the minds of most investors around the globe, the safest type of cash is the US dollar.

It is possible that precious metals, especially gold (represented by the SPDR Gold Trust ETF (NYSEARCA:GLD) and the Deutsche Bank AG DB Gold Short ETN (NYSEARCA:DGZ)), also could draw an influx of wealth as it retreated out of other markets. Indeed, our own Elliott Wave analysis of gold suggests that it should eventually see another rally to new highs. However, a case can be made that gold could fall farther than most investors think it will before it locks in a low.

Turning now to our technical analysis, and for the moment setting aside economic considerations, what do the charts say about where the Dollar Index is headed? Recall that our firm published an article in February describing an upcoming dollar rally. The article also presented an alternative scenario in which the dollar might need to set a new low first, before eventually rallying.

With the price action during the last three months, the prospect of the dollar needing a new low is now even less probable. Our primary near-term bullish scenario for the dollar has become more attractive. Currently the dollar seems poised to break over the high of July 2012 in what could be a third wave inside a larger upward third wave or 'C' wave. Note also that the dollar is still in the upswing phase of the dominant cycle on the monthly timeframe.

A monthly close over 83.73 would probably eliminate the bearish alternate scenario entirely, and would cause the dollar to climb to at least 90.53 over the course of six to nine months.

On the weekly time frame, the form continues to look as though a corrective move completed late in 2012, which has set a base on which a substantial rally can build. This continues to be our primary scenario, with labels shown in green on the weekly chart below. Some preliminary targets for a rally in the Dollar Index include 85.50 and 89.58.

For the bullish path to continue, it would be best not to see a weekly close below 83.49.

From an Elliott wave view, the near-term bearish scenario is not entirely ruled out, and the dollar could require a new low before completing a large, downward ending diagonal pattern. The near-term bearish scenario is shown with red labels on the weekly chart. However, for several economic and technical reasons, the prospect of anything other than a dollar rally is becoming ever less likely.

This article originally appeared on Trading on the Mark.
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