What Should I Do About The Recent Rally Of The Dollar?

| About: PowerShares DB (UUP)


The current strength of dollar is not likely to remain in place in the long term.

However, thanks to the divergence of policies among the central banks, the strength is likely to remain in place in the short term.

The euro is likely to remain pressured due to the political risk in some Eurozone members.

The technical picture favors a continuation of the dollar rally.

The dollar has pronouncedly appreciated since the US elections. To be sure, the PowerShares DB US dollar Bullish ETF (NYSEARCA:UUP) has gained 4.5% while the euro has lost 5% vs. the dollar during the last 3 weeks. As the recent rally is just a continuation of the ongoing 2-year rally of the dollar, many investors should take some critical decisions on their portfolios. On the one hand, those who hold stocks that generate most of their profits abroad, such as Philip Morris (NYSE:PM) and McDonald's (NYSE:MCD), should be prepared for lackluster earnings growth of those companies due to the currency headwind. On the other hand, foreign investors who have converted their cash from their local currency into dollars should determine whether it is a good opportunity to convert their cash back to their local currency to lock in a great profit.

As my portfolio has exhibited excellent performance and has widely outperformed S&P (NYSEARCA:SPY) in the last few years, I have let it roll without any intervention in the last few months. Even better, the recent rally of the dollar is an additional tailwind, as it has boosted the value of my portfolio in my local currency, euro. Thus I have reached a critical point, at which I should decide whether I will lock in my currency gains at the current rate or I will wait for the dollar to rally even further. To make the correct decision, I should determine whether the recent rally is justified and identify the main risk of locking in the current exchange rate.

First of all, the recent rally of the dollar has resulted from the pledge of the new US President-elect to spend great amounts on infrastructure in order to provide a boost to the economy. This strategy is expected to result in accelerated economic growth and higher inflation, which in turn will result in higher interest rates and a stronger dollar. While this way of thinking is not unreasonable, it does not take into account the high US debt, which has remarkably grown in the last few years and currently stands at 104% of GDP.

Click to enlarge

While this amount of debt is still sustainable, it cannot keep growing much further without negatively affecting the economy, particularly at higher interest rates. Therefore, I believe that the new US President-elect will not be able to add much debt and hence he will end up spending much less on infrastructure than he currently intends to. Consequently, I find the current enthusiasm of the market somewhat overblown.

In addition, the rally of the dollar in the last two years has largely resulted from the decoupling of the policies of the central banks. While the European Central Bank [ECB] is still in a QE program, the Fed is in a tightening mode. However, the ECB cannot maintain its current policy indefinitely. While it is expected to keep its policy intact for most of next year, at some point it will have to switch to a neutral or tightening mode. Therefore, the boost to the dollar from the divergent policies will probably be lost at some point in the next 12-24 months.

On the other hand, the technical pattern is markedly bullish for the dollar right now. More specifically, the exchange rate with euro has fallen for a third time in the last 2 years to the decade-low of 1.055. In the last two occasions, the exchange rate bounced steeply as soon as it hit the low whereas it now continues to hover around that level. In addition, experience has shown that the bounce off a bottom is always steep, which is not happening right now. Therefore, the odds are relatively high for the EUR-USD rate to break down to a new multi-year low in the near future. Of course there is no guarantee for this; the technical trend just seems to favor such a scenario. If this new low materializes, the rate is likely to fall at least to the range 0.95-1.0. Therefore, I am willing to wait for a better point to lock in the EUR-USD rate.

Click to enlarge

Unfortunately, it is not that simple to lock in the EUR-USD rate at a decade low without any risk. To be sure, apart from the ongoing QE program of the ECB, the euro has an additional reason for falling to a decade-low level. This is the political risk of a potential exit of one or more members of Eurozone. If the referendum in Italy this week turns out as expected, Prime Minister Renzi will retire and the alternative party "Five Star Movement" is likely to come into power. While the intentions of this party are largely unpredictable, it may attempt to drive Italy out of Eurozone, as many Italians are fully dissatisfied with the Eurozone experiment.

France is also having its presidential elections next spring and the far-right candidate, Marine Le Pen, is likely to win the first round. Le Pen has repeatedly stated that she will hold a referendum for exiting Eurozone if she wins. At the moment the polls show that Le Pen will not be able to beat her mainstream opponent, Francois Fillon, in the second round. However, as the recent experience from Brexit and the US elections has shown, the polls may fail to predict the winner, particularly if the latter is an anti-systemic one. All in all, while Le Pen is not likely to win in the second round, there is some political risk in France. If Italy or France decide to exit Eurozone, the euro is likely to plunge against the other currencies, as these economies are among the strongest in Eurozone. Therefore, the euro has good reasons for plunging to its current decade-low level.

To sum up, the dollar is likely to remain strong, at least for the next few months, thanks to the divergence of monetary policies across the globe. Therefore, multinational companies are likely to keep experiencing a strong currency headwind for the foreseeable future. In reference to my portfolio, due to the above mentioned risk in Eurozone, I prefer to wait for the dollar to appreciate further vs. the euro while I will keep monitoring the political developments in the Eurozone members that are considering an exit. If these developments take a turn for the worse, the euro will experience further downside and hence a better exchange rate will show up.

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.