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Tuesday August 23, 2005 - 10:17:05 GMT
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Where is the $?


“It takes months and even years for monetary policy to affect what happens in the real economy, Milton Friedman taught an entire generation of economics students. And although every central banker on the globe pays lip service to this verity, they still are guided more by backward-looking indicators, such as how many people found jobs last month, than forward-looking ones, such as markets. Quarterbacks know to throw where the receiver will be, not where he is. Central bankers don't get that.”

Randall Forsyth, Barron’s

FX Trading

The German and Japanese economies are rebounding—it seems. Many believe, with good reason, this broadening of economic growth outside the US will better balance the global economy. And in the process, lead to a decline of the US dollar as both the euro and yen rise in value. It makes sense. But there’s another possibility: Maybe we are in the midst of Phase 3 along the boom/bust path of a currency cycle.

There are seven phases in the boom/bust cycle as defined by George Soros in his book, Alchemy of Finance. (These phases are applicable to almost any asset market, but are especially valuable when analyzing currencies because of the oversized role sentiment plays in the currency decision.)

1. The unrecognized trend
2. The beginning of a self-reinforcing process
3. The successful test
4. The growing conviction, resulting in a widening divergence between reality and expectations
5. The flaw in perceptions
6. The climax
7. A self-reinforcing process in the opposite direction

Our view of where we’ve been and where we are using the boom/bust cycle as a guide:

1. The unrecognized trend
a. Despite the dollar bottom in December 2004, the extreme sentiment against the US dollar carried for a month or two into the New Year. And few seemed to realize just how serious the Fed was about moving interest rates higher. There was approximately a six-month lag between when the Fed began hiking rates and when the dollar bottomed.


2. The beginning of a self-reinforcing process

a. Once the massive negative sentiment was shaken out of the dollar, during the first few of months of the year, many players realized the dollar was in relatively good shape compared to the euro.

b. After the old lows were tested in early March ’05, the dollar began to rally. But, it did not take on many riders until late April, as evidenced by open interest levels.

c. The US economy was growing relatively fast and the Fed was raising interest rates—both powerful tried and true underlying drivers for a currency. Time to buy the dollar.


3. The “successful” test?

a. The dollar trend is now in jeopardy. The reason, as laid out in the opening paragraph: improving economic prospects for Germany and Japan.

b. It is an interesting dynamic. The yield and growth arguments powering the dollar were growing a bit long in the tooth for many traders, so the re-rating of the German and Japanese economies was timely.

c. Many dollar bulls have been shaken out of the $ Index—and a key retracement level—38%--has been tested.


One of the key reasons we believe we are in Phase #3, and not further along the path is this: The level of dollar bullishness hasn’t reached anywhere near that “extreme stage.” When you think “extreme sentiment,” think of the language used by many analysts and almost all commentators near the end of 2004—the dollar will fall off the face of the earth, banana republic time for the US, was the basic message.

The chart below, courtesy of the Currency Bulletin Weekly Alert, shows there are plenty of dollar bears still in the market…plenty to represent a catalyst for Phase #4 should the dollar’s test be successful.


What might be some of the background surprises to trigger a strong dollar move into Phase 4—it’s all guesswork, but here are a few potentials:

1) The US economy posts a 5% GDP growth number in the 3rd quarter
2) The Fed hints that its raising by 50 basis points next time
3) Germany and/or Japan growth disappoints
4) China has a financial or political accident; emerging market money rushes back to the US

For now, as usual, we watch and wait and do the best we can with what we do know.

Jack Crooks
Black Swan Capital


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