The Spot Currency Market: Slouching Towards a Currency Crunch

“Things fall apart; the centre cannot hold;
Mere anarchy is loosed upon the world,
The blood-dimmed tide is loosed…”

— W.B. Yeats

YEATS’ WORDS — a vision of Armageddon — have come back to haunt me as I look at charts of major currencies lately. It seems the old trends, on which we based a lot of our assumptions about the economic world, are changing, shifting like sand beneath our feet. For example…

1. It’s common knowledge that the U.S. dollar will remain the world’s reserve currency

2. It’s common knowledge that the Canadian dollar will always be a weak sister to the greenback.

Everybody knows this, right? But I’m starting to wonder if what “everybody knows” is about to change.

I’m going to show you some charts against a background of fundamental news (like any work of art, currency charts are nothing without context). Now, I may not be as skilled as Kathy Lien and Boris Schlossberg, the two razor-sharp traders behind our currency trading service, The Money Trader. After all, they’re the ones with nine wins out of the last 11 currency trades, not I. But I do have a few inklings of insight.

TheSpot Currency Market: The Center Cannot Hold

Let’s start with the “center,” as Yeats would put it: the U.S. dollar. Many traders thought the dollar made a long-term bottom recently, testing support it’s held from way, way back in 1995:

Bottom of Dollar

Taken in this context, that steep, steep slide we’ve seen since 2002 seems like just a correction. Ah, if only that were true, amigo (hey, I’ve got dollars in my pocket the same as you — you think I want to see them go down in value?). Because if you look at the far right end of that chart above, the dollar’s rally is fizzling even before the greenback goes up to test its ’04 highs. It seems, as Yeats might say, it cannot hold.

Now let’s blow up the image in the chart to take a closer look at the recent action in the greenback. An inflection point is coming up:

Doom Looms for Dollar

Looking at that chart, you can see that the dollar bounced to break its recent downtrend. That’s the second bottom you see on the first chart. That bounce is running out of steam. Now, Point 1 shows where old overhead resistance is now support. The dollar is coming down to test it. So doom isn’t a sure bet. The dollar may bounce here. If so, let’s go on a shopping trip to Europe! But if the dollar does not hold this support, look out…

Meanwhile, Point 2 shows momentum, as measured by MACD. It appears to be rolling over and running out of gas.

Why would a continued dollar decline be important (besides the hit we all take to our wallets)? For one thing, crude oil is priced in U.S. dollars. If the dollar continues to fall, this eats away at the profits of Persian Gulf oil princes, and they have a lot of little princes to feed, not to mention quite a few comely concubines. If — and I say IF — the dollar breaks that support from 1995, OPEC may start to question the logic of pricing oil in dollars.

TheSpot Currency Market: If OPEC Repegs

If OPEC changes oil to, say, a basket of currencies, the way China just changed the peg of the yuan, then crisis time for the greenback may come round at last.

Weighing on the greenback are, as you probably know, the federal deficit and the U.S. current account deficit, which includes the trade deficit. Let’s leave the tub of arsenic that is the federal deficit alone for now. Of current account deficit:

1. The U.S. current account deficit — what we owe the rest of the world — is running at a record pace. In the first quarter of 2005, the current account deficit hit $195.1 billion, up from $146.1 billion in the year-earlier period

2. In fact, we have to attract about $2.9 billion in foreign capital each and every business day just to keep the value of the dollar steady. Stop and think for a second about just how much freakin’ money that is

3. Part of the trade deficit is due to rising oil prices. In June 2005, the trade deficit hit $58.8 billion, $3.4 billion above May’s number. Imported crude oil and petroleum products accounted for fully HALF the increase.

Rising oil prices also weigh on GDP growth, giving foreign investors less reason to invest in America.

Now let’s tackle the budget deficit. A jump in tax revenues — likely a one-time jump, but take good news when you can get it — should shrink the budget deficit to $331 billion this fiscal year, down from a record $412 billion last year, according to the Congressional Budget Office.

Still, we have to borrow money to pay for the budget deficit. Treasury debt held by the public will total $4.6 trillion this year, up from $4.3 trillion last year. Looking ahead, if things don’t change, it will climb to $6.3 trillion in 2010.

And that doesn’t even take into account the tsunami of debt that is Medicare and other government-funded programs racing toward us.

So what is holding up the dollar? U.S. GDP growth is higher than sad-sack Europe. Rising oil prices will likely lower GDP here and across the pond. Also, U.S. interest rates are high (3.5%) relative to places like Europe, Japan, and Canada and rising, with at least two more hikes expected this year. That attracts the international flow of funds.

We’ve seen oil prices pull back recently. I don’t think that correction — an ordinary and necessary part of a bull market — will last long. So what if rising oil prices slow down GDP growth enough that the Fed stops raising interest rates — or cuts them? Then we’d have a one-two currency punch of falling GDP and slipping interest rates.

TheSpot Currency Market: The Canadian Dollar

In that scenario, as a great philosopher once said, “We’re so screwed.”Now, let’s look at the Canadian dollar. Same scenario, different side of the coin.

The Canadian dollar, also known as the “loonie” for the beautiful bird on its one-dollar coins, has long been the weak sister to the U.S. dollar. Oh, how nice it is for Yanks to go shopping in Canada. But maybe not for much longer.

The loonie is in a stealth rally. Since the beginning of 2002, it has appreciated by a third against the U.S. dollar, and in November, it reached a 13-year high of 85.32 cents. It backtracked recently. But now it has broken through that short-term downtrend and seems poised to challenge the old high:

Canadian Dollar

Looking at this weekly chart, you can see that the Canadian dollar broke its short-term downtrend at Point 1. It seems destined to take a run at the November high. Meanwhile, momentum, as measured by MACD (Point 2), is turning positive and should help the loonie ramp up.

What are the fundamentals behind this?: My big, fat trade surplus, eh?:

Oil — lots of it: In fact, Canada’s exports of energy products, which account for about a sixth of the total June trade surplus, climbed 4.3%, to C$6.49 billion (US$5.37 billion) as the price of crude jumped 10%. As I said earlier, any pullback in oil prices should be short-term only. Unlike spendthrift Uncle Sam, Canada takes in more money than it puts out. The surplus widened to C$4.95 billion (US$4.10 billion) in June, from C$4.35 billion (US$3.6 billion) in May.

Interest rates are poised to rise: Canada’s benchmark interest rate is just 2.5%. But the government is openly worrying about an overheating economy. Interest rate hikes are coming, probably at the Bank of Canada’s next meeting, on Sept. 7. And with oil prices likely to keep rising, Canada’s economy should continue to do well, and interest rates will likely continue to rise.

Now, let’s get back to those crackerjack currency traders I told you about, Kathy and Boris. One thing they’ve tried to hammer through my thick Irish skull is that currencies, even more than stocks, move in anticipation of what might happen, not what is happening:

1. It’s likely that as oil prices rise, the U.S. economy will falter, and the rate hike parade will end

2. It’s likely that as oil prices rise, the Canadian economy will continue to upshift, and interest rates will rise

So am I recommending selling the U.S. dollar and buying the Canadian dollar? Not exactly. The best place to make currency trades is in the currency spot market, and if you sold the greenback and bought the loonie, you’d be tagged with the existing interest rate differential.

What I might do is find another oil-sensitive currency, one that pays almost no interest at all. I’m talking about a currency that is dependent on a strong U.S. dollar, and when the U.S. dollar falls, this other currency should plunge. Sell THAT currency and buy the Canadian dollar. You’d get a positive interest rate differential, and you could wait for Canada’s oily destiny to kick in as that rough beast, its hour come at last, slouches towards Bethlehem to be born.

If you aren’t familiar with the spot currency market, here are a few things to get you interested…

1. You can open an account with just $300 — I’d recommend more than that

2. You can earn interest each and every day, if you’re in the kind of trade I mentioned above

3. There are no commissions on trades. Instead, you pay the spread on the difference in the prices of the currencies, but it’s usually very small. Typically, $3 to $7 or $8.

Did I mention this is the most liquid market in the world? If you aren’t trading currencies yet, you might want to check it out.


Sean Brodrick
for Whiskey & Gunpowder