Dollar year in review and a look ahead to 2006
We just finished setting
up our remote office in Playa del Carmen, Mexico. Phew!
We apologize to those that are not subscribers
for the lack of free reports during this time. Those of you that subscribe to
our Head of the Trend newsletter service were kept up to date on the dollar’s
near term moves. And what a finish to the year the dollar is giving us!
With the year drawing to a close and the dollar
poised to rally from January to July 2006 we thought we’d recap why we
forecasted a strong rally for the dollar in 2005. Some readers may recall that
we said dollar bears were “looking in the rear view mirror” if they thought we’d
see a fourth consecutive year of decline.
In fact, we said buying dollars was possibly the
“Best Trade of 2005.” But that honor should go to gold as it surpassed our
upside target of $480/$500. For commodity and currency traders alike this
“anomaly” of dollar and gold strength is perhaps the most interesting
development in markets for some time.
The explanation is really quite simple. As
readers of our reports are aware, last year we showed a little known ratio that
has a high degree of fit with the dollar index. Basically, we take the ratio of
the 3-week T-Bill to 30-year yield. This shows us the market’s expectation of
short term interest rates in the US, which is the primary mover in currency
markets. We said the market was predicting higher short term rates in the US and
with Europe looking sickly, higher US rates would attract deposits.
With the upturn in interest rate expectations we
said in December of 2004 that the time had come to start buying the dollar index
because the market was projecting higher short term interest rates. But we only
bought the dollar against the Swiss franc and Japanese yen (two components of
the dollar index with the best interest rate advantage) while we also maintained
long positions in certain key commodity currencies (AUD, MXN).
In currency trading you buy one currency and sell
the other. Interest rates are a prime concern and so is value. With gold, there
is no interest rate, but we feel that it is undervalued by at least 200-300
dollars. So gold represents a long term buy and hold asset. Even while the
dollar rallied this year, we never once recommended shorting gold.
While gold is an “asset” play, currency
trading/forecasting is really much more simple than commonly believed. Interest
rates – not deficits, housing starts, Greenspan’s briefcase – are the single
main driver.
To make a simple analogy, would you prefer a
checking account that paid you 2%, 4% or even 7% on your deposits, or would you
prefer a checking account that charged you 2%, 4% or more?
Some analysts feel that paying 2-4% interest is a
fine trade off for the scary trade deficit. But if you prefer collecting
interest on your short term deposits, and can manage not listening to the
economists, you might make a very good currency trader. As ludicrous and scary
as the trade deficit is, the TICS data keep showing strong interest in our
assets.
In the following chart we show in greater detail
just how integral short term interest rates are to foreign exchange rate
dynamics. Below we show the ECB rate subtracted from the Fed funds rate (Fed-ECB=USD/EUR
rate differential). The blue line over the left axis is what annual percentage
rate the USD/EUR checking account paid you over the past six years.
As you can see, the USD/EUR checking account paid
as much as 2.5% annualized on overnight deposits in 1999-2000 and cost you as
much as 2% in November 2002. Again, this is represented by the Fed-ECB rate
differential in blue (left axis is basis points in hundreds).
The orange lines show when the checking account
crosses from interest bearing to interest charging. Currency traders, much to
the dismay of media outlets, don’t really care about much else. Note that when
the Fed/ECB bank decided to stop paying us on our short term USD/EUR deposits,
we withdrew money from the bank. When they decided to pay us, we poured money in
again.
Our clients have seen chart after chart this year
indicating why the dollar would rally in 2005. Longtime readers of our public
reports may also recall that we even forecast that once the dollar did rally off
the 80 support level in 2005 the media would shift its focus from the “trade
deficit” to “interest rates.” This is because it is the media’s job to
rationalize the moves for you. Wanting to be in the papers and on TV, many
currency analysts simply ignore the real reason currencies trend and focus on
the “She said, He said” of market noise. A contrarian armed with correct
knowledge of currency dynamics can use this misinformation to his/her advantage.
In fact, the media’s preoccupation with Fed
wording last week was very, very misleading. As you can see from the chart
above, the rate differential between the Fed and ECB began narrowing in 2000 but
the dollar rallied another 20% until the Fed/ECB rate differential went
negative. Certainly, an actual decrease in the Fed/ECB rate differential is more
important than “words.”
But the dollar continued to rally in 2000-2002
because the rate differential remained positive. Following the move to negative
territory, currency traders said “Thank you very much, we’ll do our banking
elsewhere.” The prime beneficiaries during the dollar collapse were high
yielding currencies in 2002-2005 such as the Aussie and NZD. The reason for the
dollar collapse was not the trade deficit. It was the record pace that the Fed
slashed overnight deposit rates.
One of the other “non-interest rate” reasons the
dollar did so well in 2000-2001 was that foreigners were buying our domestic
stocks like there was no tomorrow. Note that foreign stock buying (gray line)
tends to run coincident with dollar moves. While we don’t use this as a primary
indicator for dollar direction, we do find it interesting that in the 2000-2001
time frame the Fed/ECB bank was paying 2.5% interest and foreigners were buying
stocks at the fastest rate on record. That was a pretty handsome deal for
foreigners.
In our view this creates a “virtuous circle” for
the dollar against the EUR and even more so against low yielding currencies like
the Swiss franc. In case you haven’t heard, foreigners are on track to surpass
the 2000 buying frenzy. So, the well established upward trend in the dollar
against the Euro and CHF should continue in 2006 until we see a reversal in this
trend.
Our final chart deals with our forecast this
month that the dollar would suffer a sharp correction in December followed by a
“snap-back” as it would resume its rally during the seasonally bullish period
from January to July 2006.
We first analyze the currency market from an
interest rate perspective, then value. Finally, we take into account seasonal
trends. As you can see, seasonal trends show that December is one of the worst
months on record for the dollar.
Knowing this, the dollar still suffered a larger
than expected decline – larger than we expected at least. But it held above the
key 89 support last week (where we recommended to clients buying dollars again)
and has begun to rally sharply this week.
Just so you don’t accuse us of being oblivious to
the overall trend, note that we think this rally in USD is simply a bear market
one that is setting up a massive Head and Shoulders pattern.
In our final chart we show to you our long-term
forecast for 2006-2009. Note that our forecast for a rally to 95/100 appears to
be back on track. But once the dollar reaches our long held target we then
foresee a sharp pullback to the 80 level from mid 2006 to the end of 2007. As
such, we plan to cycle out of dollar longs next year and subscribers are already
aware of what currencies we plan to sell the dollar against in 2006.
Regards,
Jes Black
FX Money Trends
613 4th St Suite 505
Hoboken, NJ 07030
Tel: 646.229.5401
Jes
Black is the fund manager at Black Flag Capital Partners and Chairman of
the firm’s Investment Committee, which oversees research, investment and
trading strategies. You can find out more about Jes at
BlackFlagForex.com.
Prior
to organizing the hedge fund he was hired by MG Financial Group to help
run their flagship news and analysis department,
Forexnews.com. After four
years as a senior currency strategist he went on to found
FxMoneyTrends.com – a research firm catering to professional traders.
Jes
Black’s opinions are often featured in the Wall Street Journal, Barron’s,
Financial Times and Reuters. He has also written numerous strategy pieces
for Futures magazine and regularly attends industry conferences to speak
about the currency markets.