The U.S. Dollar in 2008: Higher Volatility and End to Bearish Trend

There could be a comeback for the U.S. Dollar in 2008, for both technical and fundamental reasons.

Currency forecasts have not really changed since last year. Economic fundamentals and the themes and issues that financial markets stare at remain the same.

But despite an almost bearish consensus about the U.S. Dollar's direction in 2008, the fundamental data of the economic and financial environment is sending mixed signals. The next few months are unclear from a trader's perspective.

What is the consequence of those contrarian signals?

For sure, the U.S. Dollar will be very choppy in 2008, probably in a wideranging market. There isn't likely to be a clear trend.

The US Index has trended bearish since the beginning of 2006. This year could see that trend finish. The Greenback will correlate strongly to each economic figure and piece of news that could give a clearer indication about the economic and financial health of the US. This argues for higher volatility and lower risk-seeking relative to previous years.

Mixed signals? No clear direction? In this case it's always interesting to have a look at the charts, to better understand the market's behaviour. Technically speaking, it is not bad for the U.S. Dollar in 2008.

Traders recently capped the EUR/USD just below Diggers and Drillers 1.50, which is the main resistance. Like in early 2005, a failing new attempt to break the high (now 1.50) would be the signal of the end of the bullish trend.

The 10 year chart also confirms this. It stretches back to the beginning of the EUR/USD cross-rate.

Let's now have a look at the 2 year chart:

The current bullish trend of the EUR/USD has a long-term support (support 2) which should be very difficult to break this year. The levels associated with this support are currently around the 1.36/1.37 area.

After the U.S. Dollar's fall accelerated in August 2007, the pair broke the resistance of the bullish channel. This resistance then became the new medium term support (support 1). This intermediary support is currently around the 1.42/1.43 area.

Those 2 supports are the principal targets of the US Dollar against the Euro in the next few months. If the USD breaks those levels and gets any stronger than that, you'll know something fundamental has changed in the relationships that govern the exchange rate.

We consequently expect a rangy volatile market with a bullish U.S. Dollar bias in the medium-term. Is this inconsistent in the context of our long-term Greenback bearish forecast? Not at all, as time frame is so important for your trading strategies. As many investors think that the U.S. Dollar will remain weak in 2008, the main risk is then ... on the upside of the U.S. Dollar.

Economic expectations are bearish for the U.S. Dollar, so any news or statistic that refutes this scenario would surprise many investors. It would be then a good time for those who fear uncertain and choppy markets to close their U.S. Dollar short positions and to naturally hedge their long gold trades (in buying back the U.S. Dollar).

Of course, the fundamental reasons for the fall of the U.S. Dollar are still in place. There are structural risks like the twin deficits which have been weighing on the US currency trust for many years now. The current concerns are of course the likely global economic slowdown in the coming months, led by the US. The possibility of a recession should not be entirely dismissed. The FED, very reactive as usual, should then ease its credit policy in its next meetings, cutting interest rates probably down to 3.50%.

However, the U.S. Dollar retains several advantages. The subprime crisis should eventually appear as a healthy correction rather than a systemic financial collapse worldwide. According to this scenario, the massive U.S. Dollar sales during the second semester of 2007 resulted from asset reallocations more than a global mistrust in the Greenback. Despite the subprime and junk bonds crisis, the Treasury Bonds and Bills remain still attractive. Moreover, the U.S. Dollar represents around two-thirds of the world's change reserves.

The only currency reserve alternative is the Euro. But we don't consider the Euro zone a safe haven with a solid economic growth. An obvious deterioration of the business climate should eventually convince the ECB to cut rates in 2008. And the European Bonds market is only 25% the size of the US one. That's why governments will continue to purchase US assets, especially China and Japan. The U.S. Dollar is still the currency with which the world does business.

Gabriel Andr�
The Daily Reckoning Australia

Editor's Note: A former Futures and FX trader/portfolio manager, Gabriel Andr� has worked in several hedge funds and asset management firms, both in Europe and Australia.

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