Why the dollar's strength may continue

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The U.S. dollar has been climbing in recent weeks, and there are reasons to think that the trend may continue.

The biggest factor is the American consumer, who is on pace to deliver another record Christmas shopping season despite weak income growth, according to number cruncher ShopperTrak. Sales on Black Friday--traditionally a key indicator for the final month of the year--climbed 0.3 percent from a year earlier. While that isn't a big number, it appears to understate spending because retailers increasingly begin their holiday seasons in early November, which showed gains of more than 6 percent.

This improvement comes against a backdrop of better employment. Initial jobless claims plunged 4 to 5 times more than economists expected last week and are now consistently below 450,000, a rarity since the 2008 financial crisis. The next big data on this front will come out Friday, when the Labor Department reports non-farm payrolls for November. It will be preceded by less important surveys from ADP on Wednesday and initial claims (a weekly number) on Thursday.

A stronger job market will also cause investors and foreign-exchange traders to worry less about the Federal Reserve aggressively printing money. That in turn could support the dollar versus other currencies, many of which face their own headwinds.

SHY One problem for non-dollar currencies is the European sovereign debt crisis. The European Union approved a $113 billion bailout for Ireland over the weekend, and more potential difficulties remain in Portugal, Spain, and potentially Italy. The euro/dollar exchange rate has also shown extremely bearish trading patterns so far in November.

The euro made a lower low in June than it did during the 2008 market crash. It then a made a lower high this month and now is heading south again. Furthermore, the speed of its rebound off the June lows looks consistent with a bear-market rally rather than a sustainable uptrend.

The other big problem for non-dollar currencies is that China is determined to defeat inflation with tighter reserve requirements for its banks, which reduces their lending. Not only will this hurt demand for commodities, which is bad for emerging markets, but it also lets the central bank cool the economy without relying solely on higher interest rates. And that, in turn, provides less incentive for yield-hungry investors to simply buy yuan and dumping greenbacks.

Another recent development supporting this trend is that the Reserve Bank of Australia appears to be done raising interest rates. That's important because Australia tends to follow the Chinese economy and is among the most popular non-dollar currencies. If rates remain unchanged Down Under, it reduces the allure of the so-called carry trade.

Recent patterns in both the interest-rate and equity markets also support the strong dollar trend. First, rates on four-week Treasury bills appear to have bottomed around 0.11 percent and have been leaking higher all year--even as the Federal Reserve adopted quantitative easing. The recent lows near the "short end" of the yield curve are higher than the 0.01 percent levels established by four-week bills in early 2010 and late 2008.

Higher lows are generally a sign that a chart is reversing higher, which is important for the dollar because it's most sensitive to short-term interest rates. So if traders start pricing in higher rates at the same time Australia is on hold and Europe is struggling, it would probably bode well for the U.S. dollar. (We have also seen evidence of this in the option market recently, where investors have been positioning for 1-3 year Treasury notes to lose value.)

Individual stocks tell a similar story as companies sensitive to the U.S. economy take leadership. Oil refiners such as Valero Energy and Tesoro, for instance, started rallying in mid-October and are now up 5 to 10 times more than the S&P 500. Consumer discretionary stocks and retailers have staged similar rallies.

Meanwhile, global-growth and emerging-market stocks have lost the edge they enjoyed over the previous five months. (See Bryan's recent analysis of the South Korean market for more.)

(A version of this article appeared in optionMONSTER's Open Order newsletter of Nov. 28. Chart courtesy of tradeMONSTER.)



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

Copyright © 2010 OptionMonster® Holdings, Inc. All Rights Reserved.


This article appears in: Investing , Options

Referenced Stocks: FXE , SHY , TSO , UUP , VLO

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