US Dollar Index Bottoming?

May 3, 2007: 10:08 AM CST

Here is the most updated weekly swing chart of the US Dollar Index, which is on par to do one of two things: Make new lows or find support & reverse (temporarily).

dollar-index-may3.jpg

Notice the two momentum divergences. We are currently experiencing a ‘buy’ divergence at a place where the market reversed in the past (2005) and odds favor a reversal in price soon from a momentum standpoint (although the trend is quite obviously down currently).

What does this mean? When the dollar (index) decreases relative to other currencies, your dollars can purchase less goods and are less valuable, even above and beyond an inflationary standpoint.

It also means, as others have indicated, that the Dow and Markets making new lifetime highs aren’t as significant as they could be if the dollar index was making new highs as well. The new price highs are less significant because the dollar is worth less.

Envision you found a great, guaranteed investment opportunity in Mexico that would return 30% in a year, and say you invested $100,000 for a profit of $30,000. The only catch is that you had to invest in pesos. When you invested, assume $1 bought 10 pesos. The investment was 1,000,000 pesos for a return of 300,000 pesos. Not bad, right?

Now let’s assume that Mexico’s pesos fell relative to the dollar by a significant amount – 50% (for illustration purposes). Let’s assume that the exchange rate now was only $0.50 for 10 pesos. To put it another way, $1 = 20 pesos. You now exchange your 1,300,000 pesos for US dollars and wind up with … $65,000 US Dollars.

So, even though your investment returned 30% in a year, you are actually DOWN $35,000 dollars because the peso was worth much less by the end of the year.

Of course, this is an extreme example, but realize that the Dollar Index has declined 33.5% since its 2002 high, which means that your dollars are worth about 1/3 less than they were in 2002.

Always cross-check inter-market relationships when determining long-term price and the implications of price on your investments. The Dow may be making new highs, but your dollars aren’t.

5 Comments

5 Responses to “US Dollar Index Bottoming?”

  1. Rick Says:

    Hi Corey!
    Can you tell me what is chart setting on this chart?
    Really looks good on weekly charts. Thanks.

  2. Corey Says:

    Thanks for the comment, Rick.

    What specific setting would you like to know about the chart? I use TradeStation, a customized MACD (3,10,16 for settings), and the colors are derived from an Average True Range function. The Chart is the Dollar Index, symbol $DXY.

    It is intended to highlight the structure of the market only, in terms of price swings. It is useful for monitoring swing highs and swing lows in price.

  3. john Says:

    this is an interesting post…can u think of how this affects the overall trend of the markets — if it could at all…specifically, if the dollar starts going up, would that have an impact one way or another on the equity markets…any thoughts?

    i only trade intra-day, but i am just curious

    thanks

  4. Corey Says:

    An entire post or analysis could be written by various experts on this subject (I also trade short-term and intraday, so I am in no way an authority on intermarket relationships involving the dollar) but logically a stronger dollar would affect more than the US Equity markets, and the relationships would be ‘push-pull’ in various directions.

    A stronger dollar would cut profits of companies conducting a high percentage of business in foreign nations (currencies), likely dragging their price lower. The Balance of Trade would likely shift back in favor of the US (though not correct) which would bolster the US Economy and help some pure US stocks. A higher dollar releases a bit of pressure on the FED to raise interest rates, because when the dollar is low, the FED needs to raise rates to make foreign investment worth-while.

    In terms of intermarket relationships, there is a stronger relationship between the US Equity Market and the US Bond market, and though the strength of the dollar clearly affects both, the relationships is never as clear as “bond prices and US Equities move in tandem.” One relationship that is a bit clearer is that commodities and the US dollar tend to have an inverse relationship, so perhaps certain commodities may decline in value, though this is probably not the case as worldwide demand increases.

    I would recommend “If it’s Raining in Brazil, Buy Starbucks” by Peter Navarro for a great, easy to read text on the Dollar, Balance of Trade, Interest Rates, and Intermarket Relationships on deeper meaning of a stronger dollar. Dr. Navarro provides excellent analysis and a foundation for learning, even if your timeframe is short term.

    I will make one note, however. In terms of falling dollars… or rising inflation… Zimbabwe’s stock market (index) rose 600% in the first quarter of 2007. Does that sound impressive? Absolutely. However, realize that their inflation rate (or decrease in relative value of their currency) was 1,000%!!! So even in this scenario, investors still lost money.

    It’s worth thinking about whether the rampant rise in the US Stock Market since July 2006 is a result of a wonderful, rising economy… or rising inflation and a falling dollar. I suspect part of the rise has to do more with inflation/decrease in the dollar than economic conditions.

  5. john Says:

    thanks for the thoughtful reply…it was very helpful and an interesting read