Does the Buck Stop Here?

2008-SEP-07

From its low on July 15th, the US Dollar Index has now rallied 9.8%, which equates to an eye-popping 69.0% annualized rate. It is the dollar's first meaningful bear market rally in three years, and I call it a bear market rally on purpose. This bounce has all the characteristics of a bear market rally. It is sharp and swift and happened without any change for the better in the fundamental outlook for the dollar.

In fact, if it has changed at all, the outlook for the dollar has worsened, which is the first reason to suggest that the buck stops here, namely, that its bear market rally is ending. As the recession in the US deepens, the probability of the Federal Reserve raising interest rates anytime soon has fallen. Consequently, real (i.e., inflation-adjusted) US dollar interest rates remain negative. One earns less interest income on a 1-year dollar deposit than the rate of inflation, which acts as a deterrent to hold one's liquidity in dollars - and for that matter, any national currency because all of them have negative real interest rates. All currencies are being debased; their purchasing power is being inflated away, which is of course a very bullish backdrop for the precious metals.

Nevertheless, gold and silver have been in a correction as the dollar bounced. It is therefore of value to ponder whether the dollar's rally has ended. If it has, the correction in the precious metals has probably ended too.

It is always useful to measure the retracement of a bear market rally compared to its previous decline. The Dollar Index fell from 92.33 on November 15, 2005 to a record low of 71.33 on April 22, 2008. It closed Friday at 78.93, so the Dollar Index has retraced 36% of its decline.

Retracements normally stretch anywhere from one-third to one-half of the previous decline. So the bounce in the Dollar Index now falls within this range, which is the second reason to suggest that the buck stops here. The third reason is clear from the following chart.

The US Dollar Index has bounced back into major over-head resistance. This resistance arises because it marks the previous low in the Dollar Index.

No one can predict the future, and this short analysis is not an attempt to do so. Instead, it simply highlights that there are meaningful reasons to suggest that the bear market rally in the dollar stops here, and by implication, the correction in the precious metals stops here too.