Wednesday, February 2, 2011

The Dollar Index: How Low Can You Go?

When looking at the Dollar Index, I am reminded of the song the "Cha Cha Slide"when the performer says, "How low can you go?"  There is no question investors believe that the Dollar is going down and that equities are only going up all courtesy of Federal Reserve Chairman Bernanke and his QE 2 policy.  Yesterday's rally in equities and concurrent drop in the Dollar served to remind me of the fact that currency devaluation and increasing liquidity remain the drivers for equities.  It has been that way since 2007, and why should it stop now?  For the record, the Dollar Index was down a hefty 0.86% yesterday while stocks enjoyed a strong trend day.  

The relationship between the Dollar and the SP500 can be seen nicely in this weekly chart.  See figure 1 with the S&P Depository Receipts (symbol: SPY) in blue and the PowerShares DB US Dollar Bear (symbol: UDN) overlaid in red.  UDN moves inversely to the Dollar Index, and for our purposes here, UDN remains highly correlated to the SPY.  For example, at points 1 and 2, the UDN peaked (or the Dollar bottomed) and stocks subsequently struggled.  Similarly, at points A and B, UDN bottomed (or the Dollar peaked), and equities found better footing.  There is probably nothing new here, but this relationship certainly serves as a reminder of what is driving stocks.

Figure 1. SPY v. UDN

But let's get back to our question: "How Low Can You Go?"  Investors believe there is no limit to the "mad man" Bernanke; he will stop at nothing to devalue the Dollar and pump up stocks.  While this is widely believed, a weekly chart of the Dollar Index says differently.  See figure 2.

Figure 2. Dollar Index/ weekly

Although the Dollar Index has been crushed, it really has been crushed all the way back to trend line support, and this is trend line support going back to the bottom in the Dollar in 2008.  This is a rising trend line formed by a series of higher lows, and this is bullish until it isn't.  In essence, the trend line has yet to be violated and most importantly, it has yet to validate the belief held by investors that Bernanke and company are out to devalue the currency.  In addition and what should be readily apparent, the Dollar Index is at a critical level.  Failure of this trend line to hold, and it is lights out for the greenback, and equities (and all assets for that matter), which have been acting like all is well, should go ballistic to the upside.  How else can you interpret it?

What is the likelihood that the Dollar Index will bounce?  Return to figure 2 and look at the indicator in the lower panel.  The indicator measures the distance that the current price is from its 40 week moving average.  The Dollar will normally find a bottom (temporarily or tradeable) when it is about 6% below the 40 week moving; the current value is 5.28%.

Once again, the Dollar Index remains the key for equities.  The Dollar Index is at an important level, and failure here will validate the notion that Ben Bernanke is really out to destroy the greenback.  

So "How Low Can You Go?"  We are about to find out. 



hettygreen said...

In many respects the Dollar chart currently resembles the '08 bottom. Bearish sentiment is actually greater now so it's hard to envision it not bouncing but strange things are afoot in these markets so who really knows what lies ahead with any asset class?

Guy M. Lerner said...

I would agree with you and it has become difficult to trust what you see anymore. My point is that investors are of the strong belief that the Dollar is doomed and this is Bernanke's policy. However, the price action has yet to validate such a policy as we have been here