The U.S. dollar is a key factor affecting the global equity and commodity markets. Most times, a rally in the U.S. dollar leads to fall in equity and commodity prices.
Now the fundamental and technical factors point to a potential rally in the U.S. dollar. Fundamentally speaking investors rush to the U.S. dollar when the risk in the global economy increases. The U.S. dollar is considered a safe haven. The deepening troubles in Europe along with slowdown in Asia have made investors risk averse. This has resulted in a sell off in the equity markets and a rally in the U.S. dollar.
The markets react to both technical and fundamental factors. A majority of traders and investors make decisions based on the fundamentals of an asset class. On the other hand, technical analysis has a small following. Unfortunately the followers of both groups have a disdain for each other. But it's wise to trade and invest looking at both factors.
Given the fundamental clouds gathering over the global economy the U.S. dollar should have rallied much higher. To measure the U.S. dollar we are looking at the Dollar Index, which measures the greenback against six major currencies. The Dollar Index chart is below.
Note that the 83.56 level is an area of resistance. Resistance areas are where supply exceeds demand, leading to a fall in price. In August 2010, the Dollar Index sold off from the 83.56 level marked by the red horizontal line. It came and hit that level in June 2012 and sold off again. Now the index is back at that level.
Despite the weak global economic fundamentals, the only reason the index did not rally was because of that resistance level holding prices back. The more times the level is hit the weaker it gets and is eventually broken. Equity bulls and dollar bears should watch that level closely. If the index rallies above it, given the economic fundamentals, the rally will be strong and so will the sell off in equities. However, prices must close above the level for this scenario to unfold.
The half measures that Europe is using to fix the crisis inspires no confidence in the markets. As a result, we are seeing a strong bearish trending emerging in the markets. The fundamentals seem ripe for another sell-off, we are waiting for technicals to follow suit.
The looming danger to the dollar rally is another round of quantitative easing by the Federal Reserve. The FOMC meets at the end of July and its outcome is important to watch.
Once the Dollar Index closes above 83.56, we'd go short on the equity market. We'd stay short till the index nears its next resistance level at 88.85. However, if the index closes below 83 after breaking above 83.56, we'd get out of our short positions in the equity market.