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The U.S. Dollar Completes Bearish Head and Shoulders

|Includes:FXA, FXC, FXF, GLD, IAU, SLV, PowerShares DB USD Bear ETF (UDN)

After a strong rally through the first half of the year, the U.S. Dollar has since taken a nosedive which has many people worried, and most politicians secretly rejoicing.

The truth is that under the cover of strong U.S. Dollar rhetoric, our leaders in Washington have for the best part of 40 years, with a few notable exceptions like the 1993 to 2001 resurgence, promoted a weak dollar policy.

According to many of the nation's and the world's top economic and monetary authorities, after more than half a century as dominant global reference currency, the U.S. Dollar is well on its way to losing its dominant status. As investors, this is the stuff we should really know about and understand, even if it is not popular. Our future wealth depends on it!

The beauty about historic data is that it does not lie. You can debate how strong or weak the dollar is, has been or is going to be, and who is to blame, but the facts lay it all out very clearly:

  • Since 1971, when the Dollar's gold peg was broken by President Richard Nixon, the U.S. Dollar has lost over two thirds of its value against "hard" currencies like the Swiss Franc
  • Since the beginning of 2002, almost 9 years ago, the U.S. Dollar Index has lost over 35% of its value against a basket of foreign currencies (the Euro, Japanese Yen, British Pound, Canadian Dollar, Swedish Krona and Swiss Franc)
  • Just yesterday, the U.S. Dollar marked new major lows against gold, which has been the best long-term store of value for millennia, and a new all-time low against the Swiss Franc

The chart below shows how various currencies - and gold is increasingly acting like one - have fared against the U.S. Dollar since the beginning of 2009 (the U.S. Dollar being the 0% horizontal line.)

Most currencies gaining against the U.S. Dollar
Currencies gaining against the U.S. Dollar

Gold is up nearly 50% in dollar terms since the beginning of 2009, and it is not alone. Precious metals as a group are way up, silver gaining almost 90%, and so are commodities from copper to corn. The strength in hard assets is also reflected in resource-based currencies like the Brazilian Real and the Canadian and Australian Dollars. All of which points to an inflationary trend. But it’s difficult to find a currency that has lost ground against the U.S. Dollar, even the Euro which had been declared dead during the recent sovereign debt crisis has managed to stay about even.

Just last week, the U.S. House of Representatives took one step closer to an all-out trade war with China by voting in favor of legislation that would allow the U.S. to impose tariffs on Chinese goods. The bill is intended to pressure China to stop manipulating the Yuan and to let it rise faster against the U.S. Dollar. As they say, “you don’t throw stones if you live in a glass house”. Yes, the Chinese are currency manipulators as they have actively pegged the Yuan to the U.S. Dollar since July 2008, but there are no bigger currency manipulators than the United States themselves. What’s more, the U.S. depends on foreigners to keep buying our Treasuries, including China who has become the biggest foreign holder of U.S. debt paper.

The weak Dollar policy is calculated and intentional, although there will ultimately be unintended consequences. Washington wants a low Dollar to favor what export industry is left, and a high Yuan to make Chinese products more expensive here to curb imports. But the more important reason is that the policy not only fuels liquidity creation and deficit spending, but the dirty little secret is that currency devaluation is the chosen path for dealing with the ballooning debt (borrow now and pay it back later in cheaper dollars.)

The U.S. Dollar fundamentals look very bad. The fiscal and monetary policies of the U.S. Government have been leading to enormous triple deficits (Trade, Budget, and Current Account). At their most recent meeting the Federal Reserve worried about “uncomfortably low inflation” and pretty much promised more quantitative easing (creating more Dollars to buy Treasury bonds and other debt instruments) to help the economy.

Technically speaking, the U.S. Dollar looks as bad as it does on fundamental merit. Its failure to break through overhead resistance near the 2009 high earlier this year signaled it was headed lower, and it has since lost over 12%. What’s a lot more damaging for the Dollar’s future prospects is that by breaking below 80 the U.S. Dollar Index (see the chart below) has completed one of the most reliable trend reversal patterns in technical analysis: the “head and shoulder”.

U.S. Dollar completes bearish head and shoulder pattern
U.S. Dollar completes bearish head and shoulder pattern
The topping formation we have seen developing for the better part of this year is confirmed by the completion of the “right shoulder”, which just happened when support was broken at the neckline. Another feature of the head and shoulder pattern is to provide a potential target using the measured move technique. The theory is that once completed, the bearish formation should lead to a downward move of at least the distance travelled from the top of the head to the neckline. In our current U.S. Dollar Index scenario, the rule gives us a target of 72 in the not too distant future, and a retest of the all-time low.

Technical analysis and head and shoulder indicators offer no guarantees, but when coupled with overwhelmingly poor fundamentals, they are warnings well worth heeding.

To keep the size of this article manageable we split out the second part as our next article “Dollar Proofing your Portfolio.”

Disclosure: Long FXA,FXC,FXF,GLD,SLV