Investing in the Currency Market: How the Shift in the U.S. Dollar Supports Investing in Currencies

by Guest Editorial

Investing in the Currency Market: How the Shift in the U.S. Dollar Supports Investing in Currencies

by D.R. Barton, Jr., Advisory Panelist, Mt. Vernon Research

Friday, September 29, 2006: Issue #586

Editor's Note: Based on the U.S. Dollar Index, the greenback's international value is 14% lower than it was in March of 1973, when the Index was created. To be sure, the U.S. dollar has seen better days. D.R. Barton, co-author of the best selling Safe Strategies for Financial Freedom and trading specialist for Mt. Vernon Research, follows the world currency markets in real time. And today he explains why the U.S. dollar is on the mend... and how you can profit from the upswing.

Today, in Newark, DE, Joe Sixpack will pay exactly $2.49 for a Big Mac (not that I bought one of the nasty things - I called up a local franchise and asked for the price!)

If the value of the U.S. dollar goes up 10% against the euro in the next few weeks, Joe can still waddle down to McDonald's - and still pay $2.49 for his Big Mac.

And if the dollar loses 10% of its value over the next month? Mr. Sixpack doesn't care. He can still get his 510 calories and 25 grams of fat on a sesame seed bun for $2.49.

While world currency exchange rates really don't affect most people's daily lives too much, the world's truly great investors and traders, like Warren Buffett, George Soros and Tudor Jones, care about investing in the currency market a lot. Here's why...

How To Invest in the World's Most Liquid Market: Currency

There are several ways of investing in the currency market to make you money...

  • Portfolio Diversification: Most stocks have little correlation to the currency markets. This means that you can add another investing feather to your cap - one that can move, regardless of whether stocks are rising, falling, or flat.
  • Longer Trends: The currency market has long been regarded as one of the most "trending" markets in the world (here, "trending" means persistent movement in one direction). And when a market is trending, that means you have a better chance to profit from it.
  • Higher Liquidity: The currency market is the world's biggest, most liquid market. That means you don't have to hang around waiting for other investors moving the price of the U.S. dollar, the euro or other major currencies to the level where you want to buy or sell.

And here's the distinction: The U.S. dollar is on the verge of making its second big shift in direction this year - this time to the upside. Three factors - fundamentals, technical analysis, and trader sentiment - all point to a rise in the greenback.

Let's take a look at all three...

1. A Trio of Fundamentals

After a 10-month decline of the U.S. dollar, there are plenty of pundits out there who are worried about the dollar's long-term health. But on the flipside, there are also several reasons to expect the greenback to rise over the next few months:

  • The Fed Will Hike Interest Rates Again: The Federal Reserve has chosen to keep interest rates unchanged for the first time in more than two years. But that doesn't mean it's put the brakes on completely. The bankers have issued cautionary statements, calling this a "pause." With the economy gradually weakening, but inflation creeping higher, there's no doubt that the Fed has a tough balancing act. But the scales are tilted in favor of another rate hike - and there is a very strong possibility that we'll see one sometime over the next quarter or two.
  • U.S. Interest Rates Are Still at Attractive Levels: There's an old investment adage that says money will flow to where it's treated best. And at 5.25%, U.S. interest rates are higher than the comparative rates from the Bank of England, Bank of Japan, Bank of Canada and the European Central Bank. That bodes well for the dollar. And with the additional boost of a further interest rate hike in the offing, money will still flow into U.S. interest-bearing instruments and keep the demand for dollars growing.
  • The Oil Market and Supply and Demand Economics: Because crude oil sales are denominated in good old U.S. dollars, that means a lot of dollars are changing hands every day just to keep up with oil transactions. But with oil prices having tumbled from $78 to $63 in just a few weeks, fewer dollars are being tossed around. But despite this drop in demand, the dollar hasn't suffered much. So if crude prices strengthen again, dollar demand will also increase.

2. Breaking Another Trendline

Like most of its currency market counterparts, the dollar is a very trend-oriented instrument. Back in early February, I noted how the dollar had violated its upward trendline (shown in the chart below). Combined with other factors, this development led to me calling for a drop in the dollar. True to form, it did - and for much of the following seven months, too.

But take a look at the chart below, and, from a technical perspective, you'll see two more crucial developments:

  • The Dollar Has Now Broken Its Downward Trendline: Having established an uptrend since early 2005, the dollar broke that upward trendline in early January this year. Now, however, the currency has broken through its subsequent downward trendline, and has held the slight retracement that followed. In the currency market, changes in trend have proven to be very important events.
  • Volatility Dropping Fast: The Average True Range is my favorite measure of volatility - and at the moment, it's heading down in a big way. In fact, weekly volatility on the dollar index is at its lowest point in nine years. This is very significant because low volatility is one of the best predictors of large moves to follow.

Investing in the Currency Market: The Trends

3. Smart Money Is Bullish On the Dollar

Sentiment analysis seeks to quantify and qualify investor sentiment in order to gain an understanding of what the market is likely to do next. Many tools are used in sentiment analysis, including:

  • Put/call ratios
  • Volatility measures
  • Asset flows, and
  • Sentiment surveys

One sentiment tool that I like is the Commitments of Traders report. Basically, the Commodity Futures Trading Commission (CFTC) collects data from all traders who trade in "reportable size" (a size above a threshold set by the CFTC). Given that the CFTC splits the data into three categories - Large Speculators, Commercial Traders, and Small Speculators (mainly retail traders) - this data can prove quite useful.

When it comes to sentiment analysis, I personally like to follow the activities of the Commercial Traders most closely. This is because they use futures contracts in their day-to-day activity, and often have the best read on current market conditions. And comparing their sentiment to Large Speculators reveals an interesting sequence of events.

Since Large Speculators are often long-term trend followers, they are typically most bullish or bearish when the market is about the turn. In late August 2006, the Large Speculators held their largest net short position in over two years versus the dollar, while the Commercial Traders had conversely built up to their largest long position in the dollar of the past two years.

And a look at the numbers shows that the trend-following Large Speculators are already starting to unload some of their shorts, but the less-savvy retail investors keep adding to their short positions. This is bullish news for those looking to go long on the dollar in the currency markets.

One way to participate in the currency market upswing is to consider U.S. dollar funds, such as the ProFunds Rising U.S. Dollar Investor (RDPIX), which track the performance of the U.S. Dollar Index (USDX).

Great investing,

D.R. Barton, Jr.

Today's Investment U Crib Sheet

  • D.R. Barton and the other lead analysts of Mt. Vernon Research regularly publish their profit strategies in the twice-weekly Smart Options E-Report. The group has also just issued three buy ratings in its most recent equity research. Find out more.

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