An exporter of fine California wines recently complained to me
that the strong dollar early this year hurt her profit
margin.
I asked if she had hedged any of her currency exposure.
Her reply was dismissive. "Why bother? It's a flip of the coin as
to which way the dollar's going."
Not letting go, I said that since there's a 50/50 chance with a
flip of the coin, she should hedge 50 percent of her currency
exposure.
After some thoughtful silence, our wine exporter admitted that
after following the currency markets for awhile, she found it
difficult, if not impossible, to understand what was driving them.
So, she gave up trying, did no hedging and simply hoped for the
best.
It is true that the themes driving currency markets can change
often and unpredictably. Analysis of the markets on a timely basis
is, therefore, necessary to determine which themes are currently
dominant and, more importantly, which themes will be dominant over
your time frame. Analyzing the currency markets becomes complicated
right up-front with the fact that since the foreign exchange (FX)
markets set the value of one currency relative to another, you are
always looking at themes affecting two economies, not one.
Most market analysis you read or hear about is
fundamental
- meaning it's based on economic statistics, interest rates,
monetary policy and international trade and investment flows.
Political/geopolitical analyses are considered forms of fundamental
analysis. Given all the countries that make up the FX market, there
is a vast amount of fundamental information available for
analysis.
It is for this reason that technical analysis (TA) has become
valuable. By simply observing past price action, a technical
analyst can fairly quickly determine a currency's trend, recognize
price patterns that may repeat, identify support and resistance
levels and even gauge price momentum to help determine if the
currency is overbought or oversold.
Technical analysis is based on three main tenets: 1) the current
market price reflects all fundamental information available to the
market, 2) price tends to move in trends, and 3) history tends to
repeat itself. Importantly, although TA can stand on its own, it is
best used an approach to market analysis that complements, not
replaces, fundamental analysis.
As a practicing technical analyst and new member of the FX advisory
team at SVB, I will be providing technical analysis of the global
markets on my rotation of authoring the Global Outlook portion of
ISO.
Let's begin. The U.S. dollar index (DXY) is always a good place to
start when analyzing the currency markets. It is a tradable
index,and has worldwide acceptance as a measure of the value of the
dollar against a basket of six other major currencies (the euro,
Japanese yen, U.K. pound, Canadian dollar, Swedish krona and Swiss
franc).
U.S. Dollar Index 1971-2009
Source: Bloomberg
In the chart nearby we see the DXY's historical price movement from
1971 - when President Nixon took the dollar off the gold standard,
allowing currencies to float - to today. To give some fundamental
perspective I have added a number of major world events that had a
strong influence on the value of the dollar. I look at very
long-term charts to help determine the big picture - to see how the
dollar generally moves over time, and, of course, to get a good
idea
hopefully where the dollar is currently trading
within that big picture.
At first glance, you can see how few long-term trends there are -
five, maybe six, if you count the price action in early 90's as a
sideways trend - and they last five to 10 years. There are many TAs
(myself included) who consider the dollar sell-off that ended last
summer as the end of a long-term downtrend and the beginning of a
new dollar uptrend. If history does indeed repeat itself, we should
be seeing dollar strength over the coming years.
U.S. Dollar Index 2008-2009
Source: Bloomberg
Now that we have established the long-term, or secular, trend,
let's try to figure out what may happen in the medium-term, which I
define as over the next two to six months. In the weekly chart
nearby the dollar seems poised to drop to lower levels, yet within
its four-month-old down channel. There is certainly good potential
for it to reach the 75.00-76.00 area where the bottom of the down
channel coincides with a previous low, but given the assumed
secular dollar uptrend, I really question the dollar's ability to
hit new all-time lows below 71.30.
So, there you have it. The dollar may remain bearish over the
coming months, but then rally and continue within its long-term
bullish uptrend.
One important parting comment: technical analysis is not an exact
science. There are no guarantees that the prices will move exactly
to the levels we have discussed here. We live in a world of
probabilities. What I put forward as a technical analyst is that
there is a greater probability of the dollar dropping to 75 than
there is for it to rally to 85 over the coming two to six
months.
Oh, wait! Let's not forget our wine exporter. She, of course, is in
high spirits and toasting her new found approach to analyzing the
currency markets. Salute!