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Fundamentals back technicals in dollar-rally scenario
The dollar's recent rally may have been kicked off by a technical situation, but this time the fundamentals are in place for a bigger move. BY BARBARA ROCKEFELLER
Just before Christmas, the U.S. dollar was staging a corrective "relief" rally, having recovered about 4.25 percent of the 12 percent it lost between the Aug. 16 low of 1.3361 to the Nov. 23 high of 1.4968.
The key question as we go into the first quarter is whether this move will persist. The answer is "yes," and here's why.
1. Euro already overbought
The linear regression line works well as an objective method for displaying trend, but you have to be careful to
FIGURE 1 — EURO OVERBOUGHT
The push above the upper channel line indicates an overbought condition. A break below the lower channel would imply the current correction is actually a reversal.
FIGURE 1 — EURO OVERBOUGHT
The push above the upper channel line indicates an overbought condition. A break below the lower channel would imply the current correction is actually a reversal.
- Source: Data — Reuters DataLink; charts — MetaStock
start and stop the line at sensible spots. Figure 1 shows the linear regression channel of the euro/U.S. dollar pair (EUR/USD) starting at the mid-November 2005 low at 1.1678. (The channel is formed by drawing parallel lines two standard errors above and below the linear regression line. Standard error is like standard deviation except the variation is measured from a straight line instead of a moving average.)
The slope of the linear regression is stable for a long time — nearly two years. But at the beginning of November 2007, the euro broke out above the top of the channel. Instead of redrawing the channel to reflect the new higher prices, Figure 1 keeps it at the same slope and extends it into the future (dotted lines). The prices above the upper channel line are overbought prices according to this measure. If you had been looking at a euro chart using the linear regression channel tool in this manner, you would have been prepared for the correction that followed.
How do you know when to stop extending the same regression line? One commonsense rule is to continue as long as major highs and lows are alternating. The October 2007 peak, for example, was followed by only the most minor of intermediate lows; then new higher highs started coming in.
It is one of the odd truths about the trading universe that some traders have an innate sense of when a currency is overbought or oversold. It may be a recognition that price moves are not alternating direction as usual.
FIGURE 2 — HEAD-AND-SHOULDERS PATTERN
A break below the head-and-shoulders pattern neckline could take the euro back to 1.4100.
It may be some inner sensor that notes a price has moved too far or too fast without the usual profit-taking.
There are many indicators for identifying overbought-oversold conditions, but none is more accurate than trader gut feel. The linear regression channel probably comes as close as any tool to what is going on in the top trader's mind.
Figure 1 also includes the 100-day moving average (red) at 1.4226 and the 200-day moving average (green) at 1.3892, which sometimes provide support in a corrective situation. Sometimes a "reversion to the mean" occurs, which in this context would be a return to the linear regression line at around 1.4170 at year-end. But ultimate support lies at the channel bottom at 1.3820 at year-end. The last time the euro was overbought on the channel basis in May 2006 at 1.2970, the correction went all the way to the bottom of the channel (1.2512) by mid-October. However, there are too few instances of channel-based overbought signals to say the maximum opposite move is a likely result. But like a Boy Scout, you want to be prepared. At the very least you can consider the channel bottom a worst-case level (or a best-case profit target) and, if it is broken, you need to consider renaming the correction a "reversal."
2. Head-and-shoulders pattern
Figure 2 shows a head-and-shoulders pattern in the euro futures (EC). The rule is that when the neckline is broken, price will continue to fall and will rack up short-side gains equal to the
FIGURE 2 — HEAD-AND-SHOULDERS PATTERN
A break below the head-and-shoulders pattern neckline could take the euro back to 1.4100.
- Source: Data — Reuters DataLink; charts — MetaStock
entire move up from the intermediate low (1.4100).
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3. Fibonacci retracement levels
The version of Fibonacci retracement levels in Figure 3 indicates the 25 percent and 38 percent retracement levels were already broken as of Dec. 18. The 50-percent retracement level lies at 1.4208 and the 62-percent retracement level at 1.4027.
Are these good forecasts? No, if only because not everyone draws the retracement levels from the same starting point. For example, you could draw them from the intermediate low in October and get the retracement levels shown in Figure 4. In this instance, unless the countertrend move corrects all the way (100 percent), it "should" stop at the 62 percent level (1.4279).
The range of forecasts based on these three techniques is too wide. They span the worst-case channel bottom at 1.3820 or the 200-day moving average at 1.3892 (using the spot continued on p. 16
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FIGURE 4 — ALTERNATE RETRACEMENT LEVELS
Calculating the retracement levels from a different starting point results in much different targets than those in Figure 3.
FIGURE 4 — ALTERNATE RETRACEMENT LEVELS
- Source: Data — Reuters DataLink; charts — MetaStock
FIGURE 3 — FIBONACCI RETRACEMENTS
The retracement levels shown here suggest the euro has already broken the 25 and 38 percent retracement levels.
FIGURE 3 — FIBONACCI RETRACEMENTS
- Source: Data — Reuters DataLink; charts — MetaStock
EUR/USD rate) to a more immediate Fibonacci retracement of 1.4279 (using the futures). With a range like this, the difference between spot and futures quotations is hardly relevant.
Refining the forecast
Whatever indicator you prefer, once a correction has started, nerves get frayed because nobody knows when and where it will end. A correction almost always starts with a shock and is promoted by additional news on the same theme as that shock.
In the case of the euro top on Nov. 23, consider the date — the Friday after Thanksgiving, when most U.S. trading rooms were staffed only by skeleton crews. The lesson here is to be wary of new highs that occur when the market is thin. By definition, you want volume to confirm direction.
In the same week, before Thanksgiving, a rumor made the rounds the Federal Reserve was going to take "emergency" action, perhaps a rare inter-meeting rate cut. It was a strong rumor — repeated in the Financial Times newspaper — and while very few actually believed the Fed would be so tone-deaf as to scare the pants off the market with an inter-meeting cut, the idea got traction that central banks were not going to sit still much longer in the face of banks able but not willing to lend to one another out of fear of undisclosed losses.
And this was the right per-
A fair-value estimate of the euro places it somewhere between a 32- and 50-percent retracement of the entire October 2000-November 2007 move.
spective. The Fed cut rates on Dec. 11 and coordinated global emergency liquidity provisions two weeks later. The tenor of repo financing was extended out beyond the year-end, the focus of fear, and the Bank of England, European Central Bank, and Federal Reserve all told the banks they were standing up as lenders of last resort, one of their key functions.
Structural changes in the regulations governing the mortgage market are less impressive — the Treasury's plan to freeze subprime rates will benefit only about a third of those facing rate re-sets, and the Fed's plan to root out predatory practices by mortgage brokers and lenders has been seen as too bare-bones and passive to protect the consumer.
The bright side of arguably inadequate regulation is the housing market remains free to seek its own bottom. The National Association of Home Builders sees a bottom coming in the second half of 2008. This is not the grandfather of all recessions led by a housing crash. The writers of doomsday scenarios are exaggerating the threat and underestimating the resilience of the U.S. economy.
Resilience is exactly what the new dollar bulls are betting on. Retail sales remain fairly robust. Consumer sentiment — the driver of the U.S. economy — is not falling off a cliff. It's always wrong to bet against the U.S. consumer.
The trade and investment picture
Most of all, the current account deficit is contracting because of higher exports (promoted by a weaker dollar over the past two years), slower imports, and a big increase in earnings
A fair-value estimate of the euro places it somewhere between a 32- and 50-percent retracement of the entire October 2000-November 2007 move.
- Source: Data — Reuters DataLink; charts — MetaStock
from overseas investments.
Meanwhile, long-term capital flowed back into the U.S. in October after a very frightening few months of net outflow. The Treasury International Capital System (TICS) report released Dec. 17 showed that after a long-term capital inflow (revised) of $15.4 billion in September, investors came back in October to the tune of $114 billion. Total TICS, which includes short-term deposits and other short-term assets, jumped to $97.8 billion after a September outflow of $32 billion and August outflow of $150 billion. At the time, apologists said investors were grabbing liquidity from wherever they could get it — and they were right.
U.S. investors, meanwhile, sold a net $5 billion in foreign equities (from a net purchase of $21.3 billion in September and a generally rising trend). They bought fewer foreign bonds in October ($9.1 billion) than in September, too ($19.7 billion). The net swing away from overseas markets is $34 billion. This is not really repatriation (as was last year's tax-preferred continued on p. 18
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