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Friday November 9, 2007 - 11:36:38 GMT
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An Ugly Contest Indeed!

FX Trading – An ugly contest indeed!

The dollar is getting hit against the Europeans and the yen.  The yen is the big winner on the Chinese yuan news this morning.  The Comdols are getting whacked.  Is risk aversion rearing its head again? 

Though dollar selling has been brisk, we’d still have to label the decline so far as “orderly.” 
And attempt to pinpoint how far along we are in the trend, we have highlighted the seven stages of the dollar life cycle below.  Our guess is we are somewhere in Stage 5: Flaw in perceptions. 

Stage 1: Unrecognized trend
Stage 2: Self-reinforcing process
Stage 3: Successful test
Stage 4: Growing conviction
Stage 5: Flaw in perceptions
Stage 6: Climax
Stage 7: Self-reinforcing process (opposite direction)

Okay, what the heck does “Flaw in perceptions” mean?

Well, it means that we are starting to see warts develop in the economies of the other countries that represent dollar competitors, for example:

• Euro-zone growth is slowing; and the high euro is starting to bite; France is very unhappy and becoming more vocal, Italy and Spain are vulnerable to housing, and
• UK exports are being hit; housing is vulnerable; and the City’s financial service industry is vulnerable to the credit crunch; while…
• US exports and current account improve and sooner or later the decline in housing prices will clear the market of supply (we hope). 

Now, this is by no means to say the US economy is looking good or better than UK or euro-zone; it is not.  But it is to highlight that in the background, fundamentals are starting to change.  It goes unrecognized in the currency world because the trend is so powerful. And the existing rationales to sell the dollar are working very well—it is that stage where the consensus is right, and can stay right for longer than we think.  Price validates rationales.

This is the raw material that tends to make currencies overshoot their fundamental values by a significant amount—it is part and parcel to the self-feeding trend. 

And based on the looks of it, this trend has farther to go before it ends.  We do expect at least one more dollar correction before we enter Stage 6: Climax selling (maybe we are seeing outlines of that today; possibly the buck catching some of that “risk bid” we’ve been wrong about for awhile). 

Stage 6: Climax Selling represents the end of the trend.  This stage is the one that has the euro blowing through the 1.50-level and the pound to 2.15; another guess.  And once the grown-ups (if we can label government/central bank policy makers grown-ups) see this stage, it’s likely when they come into the market, intervening on behalf of the dollar. This is the Rubin-Rule stuff.  Intervention should be coincided with technical timing i.e. no one left to sell, and new rationales forming in the background.

It may sound strange thinking of the US economy looking better than euro-zone and the UK at this stage—this currency game is a relative and strange game. 

Though I have never been a judge at an ugly contest, I think currency analysis is analogous.  Boiled down to their essence, all the fiat currencies are pretty ugly.  We rely solely on the faith of our most “trustworthy” governments to insure our “stores of value,” now that is to laugh! 

So, in the currency game the winner is simply a little bit less ugly than the other.  Inherent fundamental qualities are transient.  Right now the dollar is the ugly duckling—and will get uglier in Stage 7 Climax selling.  But waiting off stage, doing their part to play catch-up, as their fundamentals begin to fade, the euro and pound will reappear.  And all of a sudden the judges will begin to see them in a different light. “Damn!  They looked a lot better in the evening gown competition.  This bathing suit thing ain’t workin for em. Ya know, the buck’s nothing to brag about, but hey, at least it can wear that suit a lot better.”

Stay tuned.  It ain’t over till its over!   

Jack Crooks
Black Swan Capital


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