A Huge Upset Is Coming in 2008...Part I

Joined : 23 Dec 2007 Posts : 239 Location : Nigeria

Today's commentary is by Sean Hyman, our Currency Director and editor of The Money Trader.

Good Day Currency Traders!

In the currency world, a huge upset is coming in 2008. And it all revolves around the most unloved, beaten-down, abandoned currency on earth - the U.S. dollar.

If you're wondering, yes, I have been looking for the dollar to fall even more for quite some time. Fundamentally, there's just not a lot propping up the U.S. dollar at this point.

But the fact is everyone on earth now agrees the dollar is doomed. And when the herd investment mentality decides any asset is "done for," you have to take a step back and reevaluate your position - because that's usually when any asset starts moving in the opposite direction. In this case - that would be up.

That's part of the reason why the dollar looks to rally next year. I see the dollar throwing the brakes on its long-term downtrend and starting to strengthen finally. But in rising, the dollar will also drag down the Dow Jones Industrial Average.

When the Dollar Goes Up,
the Dow Must Come Down

Let me explain. The Dow 30 stocks have mainly prospered because of their earnings overseas - not their profits in the United States. So these stocks have earned more money formerly because they profited from the stronger euro or pound, etc.

Once these companies made profits in euro or pounds, they had to convert those euro or pound profits back into weak dollars for their balance sheets. Hence it looked like they earned more cash than they actually did.

But the tables are about to turn in 2008. The pendulum has swung too far in one direction for too long. And now it's finally swinging in the opposite direction - in the U.S. dollar's favor.

What to Watch for in 2008 as This Trend Plays Out
A dollar rally will spark many unexpected consequences this year.

Watch for Dow stocks to report declining earnings in 2008. These companies' CEOs and CFOs will have to blame these poor returns on a "strengthening U.S. dollar." This won't go into effect right away. It will take a while for companies and the public at large to realize it's happening. But when it does, you'll see a second wave of dollar buying.

Also, you will see global growth slowing. This will inspire traders to sell their foreign currencies and buy more dollars. (There will also be money flowing to other currencies which I'll delve into in part two tomorrow.)

Both the pound and the euro will drop against the greenback. Look for the EUR/USD and the GBP/USD to continue to fall on dollar strength. (Note: The dollar may not firm up against the Japanese yen and Swiss franc as much.)

The EUR/USD Is Already Dropping -
Just in Time for 2008

Why Is the Dollar Making a Comeback?
Once again, I know this "dollar rally" is a little hard to swallow for some. But let me explain why this is happening.

For starters, the weak U.S. dollar has already encouraged foreign investors to buy up U.S. assets. As far as the foreigners are concerned, the U.S. dollar has been "on sale." This will continue into next year.

An increase in foreign buying will spur inflation even more in 2008. We've already seen higher inflation at the producer level (PPI) and more importantly at the consumer level (CPI). Higher inflation will force the Fed to think twice about cutting rates again.

Instead the Fed will have to walk a "tight rope" in 2008. Bernanke and his team have to try to help the economy recover yet manage rising inflation. The Fed will have to decide whether a weakening economy or high inflation is more important, and attack the greater of two economic evils.

When that happens, the dollar will rally because...

1. Higher inflation will put a floor under dollar's freefall and stop the slide that it has seen in previous back-to-back years.

2. Traders will eventually see this and it will spur "short covering" in the dollar. When you cover a short, you're buying to close out that position. So this alone will cause even more dollar buying. Traders will begin to see that there's more risk of a reversal upward than a continuing downtrend dollar trend. (The USD Index is at a 30-year low as of this writing.)

3. Carry-trades will unwind. Investment money will flee the "lofty" high-yielding currencies and instead will run to "beaten-down" currencies, like the dollar.

4. Housing will start to stabilize with some bumps along the way. The sliding housing market may not completely end in 2008. However, we've already seen some numbers meet or beat expectations (Housing Starts, Building Permits and Pending Home Sales).
There will be more bumps along the way and more negative numbers come out. However, just the fact that the market can see the end in sight will cause traders to preemptively buy the dollar. The market always likes to trade in anticipation of what's coming by at least six month's time. So the full recovery may not happen until 2009 in housing, but that doesn't matter. If traders can just see the end in sight, they'll start buying dollars.

5. Some commodities have hit a brick wall. With a global slowdown at hand, you'll likely see oil retreat a bit from its present levels. Oil and the dollar trade inversely over time. So as oil retreats in the near term, traders will start buying more dollars. Also, other metals have declined such as copper. This commodity decline will help to put a floor under the dollar.
(Note: Not all commodities will fall. For instance, the grains have been very strong as demand increases and the supply decreases.)

Recap: The U.S. dollar will rally against both the euro and the Great British pound and the Dow Jones Industrial Average will decline in 2008.

Happy New Year's Eve!
Sean Hyman, Currency Director