4 Reasons The Dollar Should Be Higher And One It's Not

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Summary

Reason one - Interest rate differentials.

Reason two - Economic growth.

Reason three - Global uncertainty.

Reason four - Fear.

November 8th looms large.

The dollar has stalled since the incredible rally that took the greenback from under 80 on the dollar index futures contract in May of 2014 to over the 100 level in March of 2015. Since March, the dollar index has traded in a range between 92 and 97.61. The dollar has gone to sleep, and that is a bit counter-intuitive. The midpoint of that move is 94.805.

On a longer-term basis, the dollar index has traded in a range from 70.805 to 121.29 since 1988. The midpoint of that range is 96.05. The midpoint of the two ranges is 95.43, and the dollar index was trading at 95.470 on September 29.

The dollar is the reserve currency of the world because of its stability. Central banks around the globe hold dollars as part of their foreign exchange reserves. The world perceives the United States as the most stable economy in the world and the economic leader. While China is nipping at America's heels, the U.S. economy is still the largest in the world.

There are four significant reasons why the dollar should be a lot higher against other currencies than its current level. However, one issue could be holding the greenback from gains these days. The dollar looks like the best paper money out there. However, its competition is not all that attractive.

Reason one - Interest rate differentials

When compared to interest rates in other major countries in the world that have fully convertible currencies, the dollar offers the most attractive yield.

The Fed Funds rate of 25-50 basis points is historically low, but in Europe and Japan, the same interest rates are in negative territory. Additionally, while the United States ended its quantitative easing policies in 2014, Europe and Japan continue to buy back sovereign, and in some cases corporate, debt issues.

The interest rate differentials between the dollar and other key currencies provide a case for a higher dollar.

Reason two - Economic growth

The U.S. economy has been growing at a moderate pace over recent years. A 2% growth rate is certainly nothing to write home about, but it is higher than the economic expansion in Europe and Japan. Additionally, the U.S. unemployment rate of around 4.9% is almost at what economists call full employment. In Europe and Japan, jobs and productivity remain problematic.

In Europe, the influx of immigrants has caused unemployment, particularly among younger workers, to skyrocket. In Japan, the ageing population has resulted in historically low rates of productivity.

While economic growth in China and India remain the highest in the world, the yuan and rupee are currencies that cannot compare with convertible and liquid foreign exchange instruments like the dollar, yen, and euro. Therefore, economic growth is another reason that the dollar should be moving higher these days.

Reason three - Global economic uncertainty

2016 began with a brutal sell-off in Chinese stocks that caused equity markets around the world to falter. The S&P 500 dropped 11.5% over the first six weeks of this year in response to weakness in the Chinese equity market. This Asian contagion also prevented the U.S. Fed from hiking rates over the first half of 2016. Economic uncertainty has been one of the hallmarks of this year.

In June, the results of the referendum in the United Kingdom shocked markets as Britain voted to divorce from the European Union. Brexit added to economic uncertainty. The consistent level of economic uncertainty around the world should be bullish for the dollar.

Reason four - Fear

Global political risk has also been an issue facing markets this year. The humanitarian refugee crisis in Europe with a flood of immigrants flowing onto the continent from Syria, Iraq, and North Africa was one of the reasons for the Brexit results. The refugee crisis has also contributed to the heightened fears of terrorist activity in Europe. Attacks in France and Belgium and concerns about future violence directed against European targets are a core cause of political uncertainty and the rise of fringe, nationalistic political parties in recent elections.

In Asia, North Korean provocation when it comes to the country's nuclear weapon and missile program have caused uncertainty to sweep across South Korea, Japan, as well as the rest of the world. The continuation of terror-related stress in the Middle East, Turkey, and North Africa continue to weigh heavy on the minds of investors and political institutions around the world. Moreover, strains between Saudi Arabia and Iran and Russian influence in Ukraine, Crimea, and the Middle East are a constant reminder that the world is a political tinderbox.

During times when global fear rises, the dollar has traditionally served as a safe harbor currency. Therefore, global concerns provide yet another reason why the path of least resistance for the dollar should be higher.

November 8th looms large

There are so many reasons that the dollar should be higher than its current level. However, since the rally that took the dollar from under 80 in May of 2014 to just over 100 in March 2015, the dollar has gone to sleep. The reasons that the dollar began to rally remain intact. The Fed ended its QE program and signaled that short-term rates would begin to increase.

In December 2015, the central bank raised the Fed Funds rate for the first time in nine years and promised 3-4 more hikes in 2016. However, with October only days away, the short-term rate has not moved by one basis point so far this year. The Fed has used a succession of excuses to leave rates unchanged, but once in a while they have issued statements pointing to an "imminent" rate increase.

The U.S. is in a gradual tightening cycle and that should be bullish for the value of the dollar versus other currencies. However, throughout 2016, one event has loomed large for the Fed and now it is less than six weeks away.

On November 8, the United States will go to the polls to elect its next President. The election has turned into one of the most contentious contests in modern history. The two candidates each have the lowest popularity ratings ever for such an important election.

Right now, the polls are close with the Democrat holding a marginal lead. However, if Brexit taught us anything, in a year where emotions are running so high, the outcome of any election cannot be predicted with a high degree of confidence until Election Day ends. The pound moved from $1.50 to $1.30 in the wake of Brexit.

The eyes of the world are on the U.S. election as some of the major issues have been trade and U.S. military involvement around the globe. Therefore, the election is the likely reason for a dollar that is trading close to the middle of its short- and long-term trading ranges. On November 9, all bets could be off on the dollar, and we could see a significant move in late 2016 and early 2017 depending on the outcome of the contest.

While all signs point higher for the dollar, momentum is problematic on both the long- and short-term charts.

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The quarterly chart of the U.S. dollar index futures contract highlights that a momentum indicator, the slow stochastic, is in overbought territory and has crossed to the downside. The level of the slow stochastic is telling us that technically, the dollar is setting up for a downside correction.

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On the daily chart, the same measure has moved to neutral territory, but the trend continues to be marginally lower.

When it comes to historical volatility of the dollar index, the quarterly measure of variance is at 8.71%, while the daily stands at 5.71%. The dollar index moved 28% higher during the ten-month period from May 2014 to March 2015. If the dollar is setting up for a big post-election move, one way to position for that volatility with limited risk is to consider the options market.

The chief determinate of option premiums is implied volatility or the market's perception of future volatility. Implied volatility tends to be a function of historical variance as history tends to repeat itself. The bottom line is that put and call options are currently cheap on the U.S. dollar index given the potential for a big move after the election season ends.

There are lots of reasons that the dollar should be higher these days, but the U.S. election has caused the currency to remain at the midpoint of the short- and long-term trading ranges. Volatility could be returning to the foreign exchange market soon, and options could be the best way to position with limited risk over the coming months.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.