Dollar on path for a crisis

TOMI KILGORE'S MARKET MAP

Commentary: Will Paulson rescue a dollar on the verge of breaking down?
By Tomi Kilgore, MarketWatch

Last Update: 12:02 AM ET Nov 14, 2006


NEW YORK (MarketWatch) -- A lack of words can speak a lot louder than the words themselves.
The currency market can be very frustrating for traders, because it doesn't always follow a clear fundamental logic. It can rise and fall in unison with bond yields, but also with bond prices; it can fall on a widening trade deficit, but it can also rise if that deficit is expected to lead to increased pressure on politicians to act.
It can also fall when the U.S. says, and when it doesn't say, it has a strong dollar policy.
The dollar is moving toward a crossroads. The U.S. Dollar Index, which tracks the buck against a handful of the world's major currencies, has been consolidating along an uptrend line that began in December 2004, but also along a downtrend that started in November 2005.
Given that the trendlines are on path to intersect, the dollar will be breaking out soon. Technically speaking, it looks very likely that the direction will be to the downside.
With China and other countries freely talking of plans to diversify their foreign exchange reserves, which have been predominantly comprised of U.S. dollars, the FX hordes now have a fundamental excuse to push for a breakdown. Read more.
That would certainly run counter to the U.S.'s stated "strong dollar" policy at a time when a weak currency is certainly not necessary.
If new Treasury Secretary Henry Paulson, Jr. doesn't want to deal with another currency crisis, like his ex-Goldman Sachs predecessor did more than a decade ago, he should realize that it takes more than a few unspoken words to turn a $3 trillion-a-day foreign exchange market.
Technically speaking
The Dollar Index has been bouncing along a trendline that started at the December 2004 bottom of 80.39, and touched the rising lows of March 2005 (81.28) and several monthly lows in 2006 (May's 83.60, June's 83.72, August's 84.39 and September's 84.67).
It has also been tracking a downtrend line that started at the November 2005 high (92.63), and capped several monthly highs in 2006 including March (91.16), April (90.40) and October (87.30).
The converging trendlines can be interpreted as a "pennant" continuation pattern. Chart watchers believe it represents a rejuvenation period following a sharp move; sellers are restocking for another push lower.
To make things even simpler, the index is below the 200-day simple moving average, which is seen by many as a bull vs. bear market pivot point. The index is also below its 200-week and 200-month moving averages.
Using a standard "measured move" projection -- subtract the height of the pennant pattern (92.63 minus 80.39) from the point of the breakdown, which would currently come in around 85 -- the downside target of a breakdown comes in around 73.
That would put the index below where it was when the buck's weakness vs. its major counterparts reached crisis proportions in the early- to mid-1990s.
The index hit a low of 78.19 in September 1992, marking the culmination of the dollar devaluation policy following the Plaza Accord agreement in 1985. Read more about Plaza Accord.
It was after this experience that the White House changed direction by bringing in ex-Goldman Sachs' senior partner Robert Rubin as Treasury Secretary to begin chanting the "strong dollar" mantra.
Former Goldman Sachs chief executive Henry Paulson carried on the chant when he was signed on as Treasury Secretary in July. But does he still mean it?
The dollar briefly dipped below the bottom of the pennant in intraday trading on Friday, before closing back above it. On Monday, the index tacked on 0.4% to give itself some breathing room.
There is room for a move up to the top of the pennant, which as of Monday comes in around 86.90, but it's more likely that any rally will be capped at resistance between 85.90 (around the highs of Nov. 3 and Nov. 6) and 86.15 (around the lows of Oct. 19 and Oct. 20).
Unnecessary weakness
As George Clooney said in the 1999 movie "Three Kings," the most important thing in life is necessity.
After the turn of the millennium, the White House told us a strong dollar was in our best interest, but it was pretty obvious that they didn't really mean it. The dollar index, which tracks the buck against a basket of its major trading partners, lost a third of its value from the February 2002 high (120.51) to the December 2004 low (80.39), but the government did nothing to fight it.
That's because a weak dollar helps ease deflationary pressures and boost profits of multinational companies -- just what the ailing U.S. economy and stock market needed at that particular time.
Earlier this year, commodities prices were running rampantly higher, and fears emerged that burgeoning inflation would derail a surging economy. Enough so, that the Federal Reserve has tolerated an inverted yield curve -- longer-term bond yields fall below shorter-term yields -- which is a condition that in the past has foreshadowed a recession.
A rising dollar was a perfect solution, so when Paulson took office in July, when front-month crude futures were trading above $70 a barrel, he obviously meant it when he reiterated the "strong dollar policy."
Should he remind us of this again, before it's too late?
Perhaps Paulson's ploy is to make his words move valuable by keeping them scarce.
But silence could be interpreted as acceptance. If the market believes the strong dollar policy is just words, it won't matter how forceful Paulson appears.
Then again, with crude futures trading below $60 a barrel, maybe the White House currently feels that a strong dollar is no longer necessary.
Besides, a declining dollar might help fix the broken yield curve (long-term bond yields are currently below shorter-term yields), by way of higher inflation expectations or just plain bond selling.
Or maybe they don't want foreign central banks to rely so heavily on dollars for their reserves.
But I seriously doubt it.
The White House managed to steer an "orderly" 30% decline in the dollar index over a 3-year period, starting in early-2002, which eventually coincided with a bottoming in the stock market in late-2002. But keep in mind that the Dollar Index started declining from 16-year highs.
It seems unlikely that renewed selling, at a time when the index was already near historical lows, the yield curve is pointing toward a recession, inflation is still a fear at the Fed and the global view of the dollar is on the verge of a secular change, would have the same effect as it did in 2002.
"If [a weak-dollar trend] developed, inflation risks would rise, making the economic climate less attractive for investment," said David Malpass of Bear Stearns. "This creates a circulatory risk -- that dollar weakness discourages investment, which in turn reduces demand for dollars, weakening the dollar."
Hank Paulson: speak now, or forget the dollar peace. Tomi Kilgore is a reporter for MarketWatch in New York.

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