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After plunging over fifteen percent since June 2010, the US dollar may be set for a short-term bounce if not a medium-term recovery.

With massive and extreme pessimism regarding the dollar and fiat currencies in general, driven by escalating fears over potential US government debt defaults, soaring inflation, irresponsible money printing by the Fed, and the possible overthrow of the dollar as the global reserve currency, fears of the “demise of the dollar” may be overblown.

The dollar’s strength or weakness has a much larger effect than many realize. It affects the stock market, bonds, commodity prices, debt levels, inflation, consumer confidence and behavior, foreign currencies, and even global policy. It is therefore crucial that investors, economists, analysts, politicians, and just about everyone else to monitor the US dollar’s movement and potential effects on markets, economies, policies, gas and food prices, standards of living, and numerous other factors.

Negative vs. Positive Views on the Dollar

The negative outlook for the dollar has plenty of strong fundamental reasons as support:

  1. US government debt is massive, even causing Standard & Poor’s to downgrade US debt.
  2. A potential downgrade of US credit by Standard & Poor’s from its top-notch AAA rating could trigger massive selling of US dollars by countries worldwide, as well as a huge hit for the US as it loses its first-class financial strength status.
  3. No end to US dollar devaluation due to massive money printing by the Fed. As long as the Fed continues to print money, the dollar is expected to continue to drop. And since no clear sign has been given as to the end of money printing, the dollar could drop more.
  4. Rising inflation, seen in commodity and food prices yet largely ignored by the Fed, will further devalue the dollar.
  5. The end of the dollar as world reserve currency could take place if the above-mentioned possibilities materialize. The end of the dollar as a “safe-haven” could quickly cause the dollar to plummet as world economies move out of the US dollar to diversify their reserves. One large source of potential trouble: China holds between 65 and 75 percent of its reserves in US dollars; a lowered rating or simply the decision to diversify could severely hurt the dollar.

The positive outlook for the dollar is largely based on the extreme pessimism and overblown fears:

  1. Bad news and inflation fears already priced in? With nearly everyone believing the dollar is hopeless, and even running to hard assets such as gold (GLD) or silver (SLV) to protect themselves form a dollar collapse, the big drop in the dollar may have already taken place. If much of the bad news is already factored in to the price, the dollar may be near a bottom.
  2. The end of QE2 will strengthen the dollar, as the Fed ceases to buy treasuries and dollar devaluation ends.
  3. Tighter monetary policy in response to soaring energy and commodity prices will ease inflationary concerns and, in turn, strengthen the dollar. The Fed has already shown some signs of future rate hikes, which would bring an end to the easy monetary policy that has severely weakened the dollar.
  4. Increased dollar buying by countries in an attempt to slow down their own currency appreciation could strengthen the dollar. As a number of currencies have seen tremendous appreciation while the dollar has fallen, some countries are finding their strong currencies to be detrimental to trade and future growth. By buying the US dollar then, some countries could attempt to slow down their own currencies.
  5. Chart technicals are showing a potential upcoming bounce or reversal.

Looking at the long-term chart of the US dollar dating back to 2001, we can see the big drop (click to enlarge images):

Yet even though the dollar has dropped significantly over the past ten years, it may be setting up for an explosive breakout to the upside. The chart above shows that while the dollar has dropped, the MACD has been rising – a positive divergence while the dollar is in a downtrend could signal a reversal. In other words, the drop has occurred on increasingly contradictory momentum and the dollar may start to rise.

If we look at a shorter-term chart of the dollar, spanning over less than a year, we can see more signs of a potential upcoming reversal:

After dropping sharply since January, the dollar is not only showing divergence in RSI (RSI has failed to make significant new lows since February while the price has dropped precipitously); but the recent candle pattern, known as a “Doji,” is a potential signal of an upcoming reversal. If price stays above that candle, that Doji could be the near-term or medium-term bottom.

Divergence is also visible in the chart of the dollar ETF (UUP):

RSI has failed to make a new low while the price has continued to drop. Such divergence often precedes a price reversal.

Potential Effects of the Dollar

Depending on the direction in which the dollar moves, investors can bet on other asset classes or companies. Historically, a weak dollar has been good for commodities, foreign currencies, large cap multinationals (such as McDonald’s (MCD) or Procter & Gamble (PG)), and service stocks (insurance, retailers, telecom, and package delivery [UPS]). A strong dollar, on the other hand, has been good for small-cap stocks (IWM) and US bonds (TLT) and has been bad for gold and commodities.

Comparing the dollar, gold, the S&P 500, bonds, and the small-cap Russell 2000 index over the past two years, we can see how the different asset classes moved in relation to each other:

It is still highly uncertain which direction the dollar will move. With all the major headwinds and potential troubles ahead, many believe the dollar will continue to fall. Yet with what looks to be extreme pessimism over the dollar’s future, extreme optimism about the future of gold and commodities, fair chances of an end to QE2 and tight monetary policy, and technical divergences in the charts pointing to an upside reversal, the US dollar may be ripe for a swift bounce and even a reversal.

If you think the dollar will continue to drop, stay with commodities like gold (GLD) and silver (SLV), oil (OIL, USO) and energy (XLE), or with large-cap multinationals like MCD and PG.

If you think the dollar may stage a rally here however (as I do), it may be time to bet on the dollar (UUP), small-cap stocks (IWM), and bonds (TLT) - or even to short commodities like gold and silver.

Either way, however, the future of the dollar will undoubtedly have a major impact on the future of markets, economies, and policies.

Source: Dollar 'Demise' Looks Overblown: Betting on a Short-Term Bounce or Medium-Term Recovery