Three Signals That It's Time to Buy Dollars

• ByMarc Chandler, RealMoney Contributor
• On 2:00 pm EDT, Friday August 7, 2009

I remain optimistic on the medium-term outlook for the U.S. dollar, even though is has recently fallen to new lows for the year against a broad swath of foreign currencies. I am not yet prepared to call a dollar bottom and recommend a strategic dollar long position. It might be helpful to share three of the factors that I will be looking for to know when it is time to buy the dollar.

Interest Rate Differentials

While U.S. five- and 10-year bond yields are above Germany's -- which are the proxy for the euro-zone -- short-term rates, which seem to be more important in the foreign-exchange market, are below similar German rates. Those interest rate differentials mean that one is still paid to be short dollars.

This has to and will change, but it will take some more time. Currently, the U.S. two-year yield is about 25 basis points below the German two-year yield, but the spread has narrowed by about 16 basis points over the past month. Given the strong likelihood of a relatively robust third-quarter GDP in the U.S. (the consensus is rising from 0.8%, Greenspan talked about the possibility of 2.5%, and a couple of former investment banks are on the record calling for 3%), the U.S. two-year yield may rise above Germany's by early in the fourth quarter.

We can use the Eurodollar and Euribor futures to review short-term rates. For the December contracts of 2010, three-month Eurodollar yields are essentially at par with Euribor yields. The June contracts of 2010 show three-month Eurodollar yields almost 10 basis points below Euribor yields. The December 2009 three-month Eurodollar yield is about 25 basis points more than Euribor.

The dollar's relationship to interest rate differentials is not linear but cyclical. At this point in the dollar's cycle, widening interest rate differentials are a precondition for a sustained advance. But to be clear, the day the U.S. short-term interest rates rise above euro zone rates will not necessarily signal an immediate commencement of a dollar rally. It often happens with a bit of a lag.

Shifting Drivers

The pattern over the past year has been for the U.S. dollar to benefit from poor news and suffer on good news. The dollar generally appreciated as the financial and economic crisis become acute, starting in the beginning of the second half of 2008 and remained firm through most of the first quarter of 2009. But as the global policy response kicked in, the dollar has generally trended lower, falling to new lows for the year in early August as equity markets reached their highs for the year.

For the dollar to sustain a rally, one of two things has to happen. Either the pattern breaks or the news stream turns decidedly negative. The latter is surely possible, but in the near term, it is unlikely. After the recent string of economic news, especially the stabilization of a number of housing reports and the unexpectedly large inventory decline estimated in the first look at second-quarter GDP, many observers are revising their GDP forecasts higher, though many haven't yet. Some have: Alan Greenspan suggested that 2.5% growth was possible, and two former investment banks have forecast 3% growth.

If the market's bias is to see the proverbial glass as half full now rather than half empty, then the only way for the dollar to rally is for the pattern to break down. One day a trend does not make. Remember that even an 80% correlation allows for the pattern not to be evident one day a week, and the inter-market correlations we are discussing rarely reach that level. Running the calculations on percent changes, the euro and S&P 500 have moved in the same direction a little less than 50% of the time since the start of the second quarter. The Australian dollar and the Brazilian real have been correlated with the S&P 500 74.5% and 76.4% respectively in the same period.

Investors who believe that the dollar's weakness has been exaggerated should monitor how the greenback responds to news and economic developments. Our hypothesis that the dollar's push lower is nearing an end is predicated on the dollar responding better to good news and retreating on bad news. This has not happened yet, but it could happen toward the end of the third quarter, as forward-looking economic data will lead many to revise up their forecasts for fourth-quarter GDP, which the Bloomberg survey found remained steady at 1.9% in June and July, even as estimates for the third quarter were doubled from 0.5% to 1.0%.

Technicals

Timing is an important part of risk management. Even rudimentary technical analysis can help an investor fine-tune the timing of entering an investment and help quantify the risk. Monitoring the price action itself will likely reveal higher probability opportunities to buy the dollar.

It is important to keep in mind Keynes' insight that the markets are like a beauty contest. The trick is not to pick who you think is the prettiest but to pick who you think others will think is the prettiest. In this context, it means understanding that the market is bearish the dollar, and using common technical tools like Fibonacci retracements and traditional pattern recognition, trying to identify their objectives, as these could be possible turning points as positions are adjusted.

Specifically, a number of these technical tools suggest the euro could rise to $1.46-$1.4850. This of course is close to what would seem to be psychologically important level of $1.50. Drawing on similar tools, the $1.73-$1.75 area is a reasonable for sterling. As these areas are entered, one should be sensitive to the emergence of reversal patterns or price action that suggests exhaustion, including bearish divergence in momentum indicators. This will help identify lower-risk opportunities to implement bullish dollar strategies.

The yen is a different kettle of fish, as it were. Two years ago, on a trade-weighted basis, the yen, which had been depreciating for the better part of eight years, troughed, and since the middle of 2007 has appreciated through early this year, the yen had appreciated by nearly 45%. Against the dollar, it appreciated by almost a third.

The dollar appears to have bottomed in mid-December 2008 just above JPY86. In late January the dollar re-tested that area, but did not really make it past JPY88. And then in mid-July, the dollar dipped briefly below JPY92 before rebounding. Many traders have drawn a line connecting these three lows. This "trend line" will come in around JPY92.50 at the end of the month and JPY93.25 at the end of September. Provided this trend line holds, the dollar has bottomed against the yen.

Many market participants would have also drawn a line off the early April dollar highs near JPY101.50 and off the June highs near JPY99. It comes in now around JY96.75 and JPY96.00 at the end of the month. A convincing break of that trend line would likely been seen as a signal of the dollar's recovery has begun, back toward the year's highs.

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