Currencies: Dollar Still In Downtrend

Introduction

Back in middle of January, I wrote a two piece article letting investors know that the US Dollar rally, which started around May 2011, was about to top out (Articles: Dollar Rally Ending - Part I & Part II). Back than, there was an universal feeling that the Europe was about to fall of a cliff, the US and EU were about to enter a recession and China was going to have a hard landing. Putting forward a Dollar top article was far from consensus, as majority believed new highs for the Dollar were just around the corner.

The two piece article I wrote, focused on the global broad Dollar strength, improved credit conditions within Europe removing the need for Dollar financing demand, and finally extreme bullish sentiment on the currency. On January 21st, in the Part II of the article, I conclude that:

"...the Dollar strength is not broad anymore, while sentiment and technicals imply bearish outcomes lay ahead. Going long the Euro as a contrarian, right around these levels might look like a smart move, but the Euro itself is also a sick currency. The same is true with the British Pound as well, so it is best to stay away from these three ugly sisters. Therefore, investors should short the US Dollar with other currencies that have better fundamentals, including the Swiss Franc, Australian Dollar, Korean Won, Canadian Dollar, Singapore Dollar, Norwegian Krone or Swedish Krona."

Since their respective bottoms, major currencies globally have rallied a lot against the US Dollar. Consider that as of today, the Australian Dollar is up over 13% since its October 2011 lows, New Zealand Dollar is up over 10% since its December 2011 lows, Canadian Dollar is up more than 6.5% since its October 2011 lows, Mexican Peso is up over 10% since its November 2011 lows, Norwegian Krone and Swedish Krona are almost 8% and 5% respectively since its Janurary 2012 lows, amongst many others. As we can see, over the last several months, it has been a awfully costly ride for US Dollar bulls. Amazingly, these same bulls still remain bullish and now they expect new highs above the January peak.

Dollar Rally?

After such a weak performance, we should not be surprised to see the Dollar rallying over the last week or so. Counter trend rallies, also known as corrections, are quite normal within a major trend. Risk assets have enjoyed a strong run up in recent months too, so as these assets experience corrections from time to time, the Dollar should of course rally for awhile due to the inverse correlation.

What really surprises me however, is how many investors from Bloomberg to CNBC, together with well respected bloggers and technical newsletters, all now expect the US Dollar Index to make a new 52 week high above 81.50 top back in middle of January. So why do I differ from this view? To answer that question, first of all, I will explain Dollar bulls thinking process and than I will try to explain why I think it will prove wrong... again!

To start of with, the Dollar bulls prefer using the chart above - DXY or US Dollar Index. These investors are not actually following the broad Dollar strength / weakness across global basket of currencies. TAs they prefer the DXY, their opinion is always "influenced" heavily by strong weighting towards sick currencies like the Euro and the Pound. Therefore, majority of these investors conclude that the Dollar's trend is currently bullish, because it is creating a serious of Higher Highs and Higher Lows (major signal of an uptrend); and furthermore it is also above its 200 day moving average. That type of a process is quite flawed and would be very similar to concluding where the S&P 500 Index will move, if we just follow a few high weighting stocks like Exxon Mobile, Coca Cola and Microsoft.

Dollar Breadth

For the sake of exposing how flawed the US Dollar Index really is and how weak the current Dollar strength truly is, I have used the DXY with the same time frame as in the first chart, but I have now applied a variety of simple moving averages to it, from the short term 5 day MA all the way to long term 200 day MA. See the chart below:

First of all, the US Dollar Index (DXY) which is 70% weighted towards the Euro and the Pound, is currently trading above its 20 day MA, 100 day MA as well as 200 day MA - and its close to breaking above its 50 day MA. That should imply Dollar strength from medium to long term perspective right? I disagree. Checking this strength against the Euro and the Pound as the majority of the index, is not a sufficient test of Dollar's strength. We need more evidence that the strength is universal, before we can conclude the Dollar has bottomed properly.

Therefore, what I have done is applied the same moving averages from 5 day MA to 200 day MA across 24 major global currencies from all continents. That means we are now following Dollar's strength against Developed Market currencies, Emerging Market currencies, Asian currencies, Commodity based currencies and major BRIC currencies. Let us compared the chart above to the US Dollar Index with all the moving averages in the table below and make some conclusions:

• Short term, the Dollar is above its 5 day MA against 100% of major global currencies. That confirms the current Dollar rally, as risk asset correct. Therefore, we should expect this to last, until the 5 day MA is broken by at least 33% to 50% of the global currencies.

• Short to medium term, the Dollar is above its 20 day MA against 66% or two thirds of major global currencies. That shows Dollar is rallying against majority of global currencies over the short term, but does not completely confirm broad strength, which should be at 75% or more. If this number starts to fall below 50%, Dollar rally could be over.

• Medium term, the Dollar is above its 50 day MA against 13% of major global currencies. The major point of difference here is that while DXY is on the verge of breaking its 50 day MA other currencies are not even close. Close to 50% or half of global currencies, including British Pound, Norwegian Krone, Russian Ruble, Mexican Peso, South African Rand and Polish Zloty are all still quite far away from their respective 50 day MAs. If the DXY breaks 50 day MA, but majority of global currencies do not confirm this, be wary of going long the Dollar.

• Medium to long term, the Dollar is above its 100 day MA against 13% of major global currencies. The major point of difference here is that while DXY is very far above its 100 day MA, hardly any other major currency is, apart from the Euro. As already noted, Euro's heavy weighting of DXY gives it "fake strength" so to speak and mask true Dollar weakness across the board. This point of difference is very major and exposes the biggest flaw with the DXY.

• Long term, the Dollar is above its 200 day MA against 66% of major global currencies. That shows Dollar is rallying against majority of global currencies, but does not completely confirm broad strength, which should be at 75% or more. Dollar bulls keep saying that DXY is still way above its 200 MA, but Euro weakness is once again the major reason for this flawed outlook. Many global currencies have recently started to crack their respective 200 day MA including British Pound, Swedish Krona, Canadian Dollar, Norwegian Krone, Singapore Dollar, Korean Won, Russian Ruble, Mexican Peso and quite a few others. If this number starts to fall below 50%, Dollar rally could be over.

Summary

It should be quite evident that, from the broad breadth analysis above, that the Greenback is much much weaker than the US Dollar Index (DXY) implies. Due to a heavy weighting towards other sick currencies like the Euro and the Pound, the DXY strength above 100 day and 200 MAs is actually masking the internal weakness the Dollar against majority of global currencies. Keep in mind that the Dollar never has a sustained rally, unless it rallies universally and broadly. On top of that, three precious metals like Gold, Silver and Platinum, which also tend to be counted as currencies, are all confirming the above analysis exposing further Dollar weakness.

Having said all that, it is a fact that the US Dollar is above its short term moving averages against majority of global currencies, which indicates that further possible gains could occur as risk assets correct. Personally, I think this strength is will fizzle out in coming days or weeks, without new 52 week highs occurring as Dollar bulls would like to have us believe. It is for this reason, and a few others not written here, why I am still keeping my Dollar short against the Swiss Franc, which I opened back in middle of January. Quite to the contrary of the consensus, which remains extremely short the Euro, and so many "gurus" and "experts" expecting new highs for the Dollar Index, I expect further Dollar downside into the end of the first half of 2012.