3 Reasons the Dollar Is About to Rally: A Contrarian Case for the Greenback

Everyone hates the US Dollar - again.

The Fed is openly signaling to the markets that it is not going to stand by the buck. The current headline article at Bloomberg.com pertains to New York Fed president William Dudley's statements that inflation is too low, and unemployment is too high, for the Fed to stand by and watch as a passive observer. Get ready for more unconventional easing measures.

Which means the poor dollar is going to get thrown out the window as the Fed revs up the printing presses at full speed. There's no hope for the greenback!

Or is there? I feel like somebody's gotta stand up for the greenback. I also think there are some key points that the mainstream financial media is ignoring in presenting this one-way trade.

So, here's a three-fold contrarian case for the dollar.

1. Contrary to Popular Belief, the Dollar's Trend is UP

But don't just take it from me - look at the chart (click to enlarge):

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New 2010 Highs in Aussie Dollar, If They Hold, Are Positive for Both Copper Prices and the Dow Transports

A continuation of recent strength in Aussie Dollar / US Dollar (AUDUSD), above major overhead resistance at its 0.9380 November 2009 benchmark high, would indicate that the Aussie's larger October 2008 major uptrend versus the US currency is resuming. Considering the tight and stable positive correlation between AUDUSD and commodity prices, and more specifically with economically-influential copper prices, continued strength in AUDUSD would indirectly suggest increasing economic demand and the likelihood of a similar rise in the Dow Jones Transportation Index.

In our September 7th Keys To This Week report we said:

"A new bullish shift in near term market momentum, plus the failed bearish chart pattern in the S&P 500, indicate that a near term bottom is in place in the broad market index at the late August lows and clears the way for at least a retest of the 1,129 August highs."

Since that report the S&P 500 has risen by 35 points or 3.2% to as high as 1,127 as of September 14th -- just below important overhead resistance from 1,129 to 1,131. A corresponding resistance level at 1140 is coincidentally being tested in the NASDAQ 100. This represents a near term decision point for the market where it must decide whether the April downtrend is still intact, or or if a retest of the April highs is on the horizon.

In today's report we attempt to answer that question by displaying and discussing what may be an emerging bullish breakout in the Australian Dollar (AUDUSD), and its potential directional implications for both commodity prices and, indirectly, the Dow Jones Transportation Index.

THE AUSTRALIAN DOLLAR'S RELATIONSHIP WITH COMMODITY PRICES

Before we focus on the directional implications of recent price activity in the Australian Dollar, let's first establish its relationship with commodity prices. The Australian Dollar/US Dollar has maintained a tight and stable positive correlation to the CRB Index over the past decade,

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John Hussman: Why QE Could Trigger a Collapse of the Dollar

Excerpt from the Hussman Funds' Weekly Market Comment (8/23/10):

A week ago, the Federal Reserve initiated a new program of "quantitative easing" (QE), with the Fed purchasing U.S. Treasury securities and paying for those securities by creating billions of dollars in new monetary base. Treasury bond prices surged on the action. With the U.S. economy predictably weakening, this second round of quantitative easing appears likely to continue. Unfortunately, the unintended side effect of this policy shift is likely to be an abrupt collapse in the foreign exchange value of the U.S. dollar.

...

In short, quantitative easing is likely to induce what the late MIT economist Rudiger Dornbusch described as "exchange rate overshooting" - a large and abrupt shift in the spot exchange rate that occurs in order to align long-term equilibrium in the market for goods and services with short-term equilibrium in the capital markets.

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Frankly, I've always thought Dornbush's use of the word "overshooting" was unfortunate, because it implies that the exchange rate move is an overreaction, when that is not at all the case. Overshooting refers to the tendency of the spot exchange rate to move beyond its long-term PPP value, but this move is in fact approprate, efficient, and required in order to align the returns that investors can expect in each currency. So it is important to avoid misinterpretation - the policy of quantitative easing is likely to force a large adjustment on the U.S. dollar because the Federal Reserve is choosing to lay a heavier hand on the Treasury bond market than would result from economic conditions alone. The resulting shift in interest rates and long-term inflation prospects combine to dramatically reduce the attractiveness of the U.S. dollar. A significant and relatively abrupt devaluation is then required, in an amount sufficient to set up expectations of a U.S. dollar appreciation over time.

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My impression is that Ben Bernanke has little sense of the damage he is about to provoke. A central banker who talks about throwing money from helicopters is not only arrogant but foolish. Nearly a century ago, the great economist Ludwig von Mises observed that massive central bank easing is invariably a form of cowardice that attempts to avoid the need to restructure debt or correct fiscal deficits, avoiding wiser but more difficult choices by instead destroying the value of the currency.

About the author: John Hussman

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