Why I Love to See the Dollar Smile
Dear Reader,
Textbook schizophrenia is defined as illogical patterns of thinking, delusions and other emotional disturbances.
Right now, traders all over the world seem to be suffering from this disorder on a day-to-day basis. It’s easy to see why.
The 2008 stock market crash is still fresh in everyone’s memory. So whenever any kind of risk event hits the markets, traders are immediately looking for another crash. That makes for a very schizophrenic market.
And there are tons of significant risks emerging in all corners of the world right now
In the U.S., the economy is showing signs of slowing down. In Europe, there’s a risk the Greek crisis will spread to other countries. In Asia, some are saying the Chinese real estate bubble is popping.
With all these uncertainties, sentiment in the currency market has been changing almost daily. Many currencies are trading all over the map.
What to do? How do you profit in this challenging, schizophrenic market?
My advice is to keep it simple…
Start by determining the overall sentiment in the market. One of the best ways to do that is to follow what’s called the dollar smile. Let me explain…
The Dollar Smile: A Simple Way to Watch Investor Sentiment
Last year, a former bank currency economist came up with the dollar smile theory. It’s a simple way to understand how the dollar behaves.
According to the theory, the dollar does best when the real and financial world looks either very good or very bad.
Take a look at the graph below. It will help you understand this simple theory.
When things are going well in the U.S., our economy leads the developed world. At those rare times when U.S. is performing well, we have the highest interest rates, and the healthiest growth. Investors from around the globe want to invest in the U.S., so a lot of investment capital is flowing our way. As a result, the dollar gains in strength.
When the U.S. economy stumbles, the dollar also gains in strength. That’s because we still have the world’s reserve currency.
If the U.S.economy were to enter a recession, for example, sentiment would go sour around the globe. U.S. investors would close their risky investments, and bring their portfolio capital back from overseas. This would drive the dollar up.
That’s exactly what happened in 2008.
Finally, when the U.S.economy isn’t too strong or weak, the dollar tends to plummet. As long as the U.S. is just muddling through, traders tend to sell the dollar and invest in higher yielding currencies.
So where are we today?
If Things Get Worse, the Dollar Will Smile
The weakness of recent U.S. economic data shows that we’re clearly not doing well. So there’s no chance the dollar will gain strength.
The other side of the smile is much more likely. The dollar has rallied a little bit in the past few weeks because of all the uncertainties I mentioned above.
But we’re still in the muddling through phase. We’re at the bottom of the smile, moving slowly towards the right.
If the global economy continues to weaken, fears of a double dip recession will pick up. Investment sentiment will turn sour around the globe. U.S. investors will close their foreign investments, and bring their money home. That will drive the dollar up.
Or in short, it will be 2008 all over again.
One of the ways I like to measure sentiment around the dollar is to watch the price action of the dollar index. The dollar index measures the performance of the dollar against a basket of other major currencies. Let’s take a look.
Dollar Remains in a Down Trend, Despite All the Fear
As you can see in the daily chart of the dollar index above, the dollar has recovered a little bit since May. But it has not been able to break above its trend line.
That shows that investment sentiment is not that bad – regardless of how schizophrenic the market has been lately. This means overall traders still think the global economic recovery remains on track.
The U.S. economy however is muddling through, so the dollar seems to be heading to new lows for now.
But that can change in a heartbeat. If investor sentiment starts to change towards a “doom” scenario, the dollar will break above that trend line.
That will be a big red flashing sign that sentiment has changed for the worse.
I’m watching for that to happen, because if the dollar starts to rise, there will be some incredible opportunities in the currency market.
Like in 2008, it will be almost too easy to buy the dollar against the weaker emerging market currencies in the spot Forex market. Some of my favorite emerging market currencies to short if the U.S. economy turns sour include the Mexican peso, the South African rand, and the Hungarian forint.
Any one of these shorting possibilities will offer some great trading opportunities.
Bottom line: Keep an eye on the dollar, and the overall sentiment in the markets. Then sit back and trade accordingly!
Best Regards.
Evaldo Albuquerque
Editor, Exotic FX Alert
