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Today's Market WrapUp 10.21.2008 Mon Tue Wed Thu Fri Barbera Archive

Getting Ready for "The Turn" in the Dollar
BY FRANK BARBERA, CMT

Over the years, I have written a number of controversial articles, some which were correct, and some which were off base. Like a player that bats .300 in baseball, in the financial markets, if you can correctly see what’s coming next more then half the time, you are doing reasonably well. I start today’s article on this note because I know that right here, right now, this article and this call are bound to be among the most highly controversial and represent one of the more aggressive calls I have made in some time. Yet, looking at the state of the currency markets, it appears as though a truly major turn is dead ahead. Now, I am writing this article from the point of view of a market technician, and I want to state up front that I have no idea “why” the Dollar will weaken, and why the Euro will bounce back. For whatever reason, I would assert that at the moment, an “inflection point” of epic proportions is now directly ahead. Of course, there is always room to speculate where fundamentals are concerned. In markets as super charged as the currency markets are at the moment, an important trend change could come from something as simple as some European finance minister opening his mouth and talking about lower rates. Alternatively, maybe some economic data could trigger a major swing. From the standpoint of the message of the charts, the fundamentals matter little. The charts are shouting out potential “trend change” and that is all we are paying attention to at the current time.

In looking at the currency markets and the Dollar markets, the current trends seem to have gone too far in one direction without any significant counter trend move. In the case of the US Dollar, it is clear that the Dollar has benefited from the unwinding of carry trades that had been implemented over the years by the hedge fund community. Looking back at the last decade, the growth of assets under hedge fund management has soared into the trillions with a substantial portion of that money leveraged in various carry trades. Chief among these was the YEN Carry trade where hedge funds borrowed sold Dollars to borrow cheap money in Japan, and then used that money to purchase assets on a leveraged basis, often in the natural resource space. Now, with hedge funds in a period of forced redemptions, a gigantic margin call of sorts have been sent out around the world, forcing these funds to unwind their leveraged trades and buy dollars to pay back their carry trade loans. As a result, the advance in the US Dollar has been driven by largely mechanical trading, and forced reversals of previously favored long positions.

It is perhaps the ultimate irony that these events have transpired at the very time that the US Government is creating billions and billions of new dollars out of thin air. In the past, other countries have walked down this road and none has ever succeeded in sustaining such an attempted reflation for long without incurring huge pain in the currency value. Yet, the US has embarked down this well trodden path in what could be ultimately seen as the road to ruin. Only time will be the ultimate arbiter of the wisdom of recent decisions. Thus, we know that with a mass of evidence to the contrary, a cloud of suspicion should be hanging over the current advance in the greenback. From here, what we need to see to validate these suspicions is some solid statistical evidence. In my view, I have found what I believe is strong evidence – statistical evidence, that the Dollar advance should be near its end.

In the chart below, I show the US Dollar Index and its one year trading band (255 trading days) going back to the late 1960’s. Most of the time, prices are contained inside the bands. On rare occasions, prices will move either up to, or in even rare occasions, outside the upper band. On these occasions when prices push outside the upper band, there are only two signals that are being given. Either the market is in ‘kick off’ mode and is signaling a major intent to move seriously higher on a sustained basis, or the movement outside the upper band is a marker for an over-extended market that is about to reverse. In such cases, the reversal is usually compelling and usually comes within just a few days.