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Down Goes The Dollar!

02/11/03 04:22:33 PM PST
by David Penn

Does a falling dollar mean that deflationary risks are overblown?

From a high of 121 in the US dollar index in 2001, the greenback has plunged to below 100 in a little over a year. As the dollar collapsed, other currencies that were just this side of laughingstocks in the 1990s soared. In 2002, the British pound gained 14%. The euro, which previously couldn't stop falling for most of its existence, took advantage of the dollar's weakness to tack on an 18% gain in 2002. Even the yen, dazed and confused by more than a decade of conflicting and often contradictory economic and financial policy in Japan, still managed to pull together an impressive-enough 12% gain against the dollar in 2002.

Measured against its own history, the US dollar is still relatively highly valued. The greenback is still trading higher than it was at most points during the 1990s. And except for the tremendous dollar volatility of the early to mid-1980s — which saw the US dollar index skyrocket from 85 in 1981 to 165 in 1985 and back to 85 by 1988 — the current level of the dollar compares favorably with its status at any point since the major world currencies began floating in the early 1970s. In fact, this relative strength is partly why, with the dollar index down some 18% in just over a year, there has been relatively little commotion in the mainstream financial press. If anything, there have been occasional voices suggesting that some dollar weakness might indeed be a good thing.

These have been the suggestions of the "reflationists," those antideflation crusaders who, realizing that an economy not experiencing rapid growth can ill-afford a rapidly appreciating currency, have been exhorting the government to, in essence, "print money" in order to keep a credit-fueled economy from collapsing beneath the weight of its own debt service.

However, devaluing the US dollar may be a more difficult task than the reflationists, led by Federal Reserve Board governor Ben Bernanke and the bond gurus of Pimco, believe it will be. There are many reasons why this might be so. Credit inflation — by way of artificially lowering the market rate of interest — is in itself deflationary because of the way credit expansion creates a greater demand for real money. In addition, foreign holders of US dollars would probably not take kindly to seeing their holdings arbitrarily reduced in value and could conceivably begin selling dollars before their value began plunging in earnest. Finally, there are technicals that actually support a higher dollar — at least in the context of the cyclical bull market the dollar has been experiencing ever since bottoming in 1995.


A little greenback history might help put into context both its current weakness and the cyclical strength I expect it to gain in coming years. The fact that the deflation scare popped up in 2002, only to be dashed away by a combination of the Federal Reserve Board's aggressive rhetoric (Bernanke's "printing press" speech) and an attitude of derision in the mainstream financial press, is interesting — particularly given the fundamental signals both politicians and the market itself have provided pointing toward deflation.

Market and economic historians have long suggested that the US dollar has been declining in value (inflation) since the increased role in the economy adopted by the government (especially the Federal Reserve Board) in the wake of the Great Depression. These measures included the tax increases of the Revenue Act of 1932 (top rates raised from 25% to 63%; personal exemptions reduced by 28­33%), the "loose money" approach of the Glass-Steagall Act of 1932 (which made it easier for member banks to borrow from the Federal Reserve) and, most notably, the abandonment of the gold standard in 1933.

With the dollar increasingly based solely on the "full faith and credit of the United States," its value against other currencies slowly began to decline. This decline culminated in the inflation of the late 1960s and 1970s when the United States decided to end dollar-gold convertibility (even after the abrogation of the gold standard, dollars had been convertible to gold at a fixed price for foreign holders), thus allowing the value of the dollar to be determined by the supply and demand dynamics of the marketplace. Given an oversupply of dollars in the late 1960s and 1970s, their value plunged.

This falling dollar of the 1970s was eventually "saved" by the courageous actions of the Federal Reserve overseen by Fed chair Paul Volcker, which virtually squeezed runaway inflation out of the economy by tightening the money supply and engineering an economic contraction. However, as the Volcker Fed gave way to Alan Greenspan's Fed, there were signs that the Federal Reserve Board once again was willing to debase the value of the dollar — by way of inexpensive credit to banks — if such a devaluation would avert a major market crash (1987), provide "growth and jobs" (1991), or bail out overleveraged lenders (as happened in 1992, with the case of Olympia and York), municipalities crushed by derivative losses (as happened in 1994, in the Orange County debacle), and massive hedge funds involved in global currency and interest rate speculation (as happened in 1998, with LTCM).

Interestingly, while the value of the dollar continued to fall relative to its long-term historical value, a change in sentiment in the mid-1990s set in motion a new attitude toward fiscal responsibility at the federal government level. This change began with the election of a pro-capitalist, "It's the economy, stupid," Democratic President in 1992, and the subsequent election of a Republican majority to the House of Representatives in 1994 — a feat that had not been accomplished in decades. From the political mood of the 1980s — in which Democrats referred to Republicans as "borrow and spenders" to counter GOP charges of Democrats as "tax and spenders," both parties moved to embrace balanced budgets, reduction of federal deficits, and free trade in the mid-1990s — three significantly deflationary initiatives.

In 1995, Robert Prechter of Elliott Wave International noted of these events:

In November 1994, voters elected a Republican Congress. The party campaigned on a set of promises called the Contract with America, which includes a proposal to amend the US Constitution to require a balanced federal budget. While it missed passing the Senate by one vote, the psychology that backed the idea remains. After electing politicians over four decades who spend more than they collect, voters want the US government to slam on the brakes. This psychological impulse is deflationary, yet no one appears to recognize its meaning.

This "deflationary impulse" continued on for the balance of the decade — particularly with the birth of "Rubinomics" (named after Clinton-era Treasury secretary Robert Rubin) and the politics of the so-called bond market vigilantes who sought federal budget deficit reduction above most other economic priorities.

The bear market that began the 21st century saw a weakening of the dollar, which had soared to levels not seen since the mid-1980s. The falling dollar — which again is still highly valued relative to its post-1970s values — has encouraged those who doubted the likelihood of deflation in the first place to believe that inflation (or at a minimum what is being referred to as "reflation") is the more apparent reality and chronic inflation the more likely danger. These notions, as I have mentioned, have only been encouraged by the late 2002 shift in bias at the Federal Reserve Board from "economic weakness" to a precarious balance between "weakness" and "inflation," as well as by the comments of Federal Reserve governors like Ben Bernanke, who said on the subject of deflation:

"Like gold, US dollars have value only to the extent that they are strictly limited in supply. But the US government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many US dollars as it wishes at essentially no cost We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation as I have stressed already, prevention of deflation remains preferable to having to cure it. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation."

There is much to comment on in this excerpt, which was part of Fed governor Bernanke's address to the National Economists Club in the fall of 2002. For this discussion, however, what are most relevant are two things: one, that the Federal Reserve Board is convinced of its ability to limit the bull market of the dollar by flooding the markets with supply and, two, the Federal Reserve is willing to "destroy" the dollar with inflation in order to prevent deflation in the economy.


The technical case for a cyclical bull market in the dollar is not overwhelming. The US dollar index fell beneath its 50-week moving average in the spring of 2002 and slipped below its 200-week moving average later that summer. And at about 100 in February 2003, the index is down some 18% from its recent peak of 121 in the summer of 2001. While this is a sizable decline, it more or less mirrors the dip the index experienced from late 1993 to its bottom in early 1995 (a drop of approximately 17.5%). But evidence of a possible rebound in the dollar's fortunes is sufficiently abundant that those convinced the dollar is headed for an inflationary abyss in the near future may want to be cautious.

For all the reflationary boasting about the power of the government's monetary "printing press," there is some distance between policy-making and what Morgan Stanley economist Stephen Roach refers to as "policy traction" (or the real-world ability of policy to meet its stated objectives). And there is a growing possibility that the next few years will be more a test of the market's ability to span that distance than it will be a straight-shot, inflationary debasement of the dollar.

Figure 1: Breaks beneath both the 50- and 200-week moving averages make a bullish reversal difficult to imagine at this point.

The first technical point in favor of a cyclical bull market in the dollar has to do with retracement levels. Measured from the 1995 bottom, the US dollar index has advanced some 40 points in order to reach its peak of 121 in 2001. Currently trading between 100 and 99, the US dollar index has reached a pivotal 50% retracement point from which support — at least in the short term — is likely. A 50% retracement is a common support level in both Fibonacci and Dow theory understandings of the role of support and resistance in price action. Writing in his Technical Analysis Of The Futures Markets, John J. Murphy notes:

The best-known application of the phenomenon is the 50% retracement. Let's say, for example, that a market is trending higher and travels from the 100 level to the 200 level. Very often, the subsequent reaction retraces about half of the prior move, to about the 150 level, before upward momentum is regained. This is a very well-known market tendency and happens quite frequently in the futures markets. Also, these percentage retracements apply to any degree of trend — major, secondary, and near-term.

Murphy refers again to the 50% retracement as "more of a tendency than a precise hard and fast rule," which is appropriate. There is no law that suggests that, for example, the greenback will halt its slide between 100 and 99. But given the 18% decline the greenback has already experienced (vis-à-vis its 2001 high) and the presence of some semblance of support from the price fluctuations between 1997 and 1999, the possibility of a rebound from the 50% retracement level should not be casually ruled out.

Another technical condition that appears to support a higher dollar in the next year or two has to do with the trend channel the US dollar index has been trading in ever since its 1995 bottom. This trend channel is so explicit that prices have only pierced the channel once — during the declines of 2002. Trend channels that enclose price action in a set of parallel lines that track both the highs and the lows can also be effective ways to spot possible support and resistance areas. While some allowance should be made for small overshoots of the trend channel, channels that have shown to effectively encompass price action over an extended trend do tend to accurately represent the rate at which a given price series is rising or falling.

Figure 2: Although overshooting the lower edge of this trend channel with the declines of December 2002, the US dollar index remains susceptible to a rebound toward higher prices.

As prices approach the upper end of the trend channel, the odds grow that a pullback to a more sustainable angle of ascent is in store. Something similar works on the downside. When prices begin to fall toward the bottom of a trend channel, it becomes increasingly likely that prices will find support just above or immediately below the trend channel line. Of course, anytime prices break through a trend channel line — especially if there is follow-through in subsequent days, weeks, or months (depending on the chart's time frame) — then there is a greater likelihood that a change in trend has occurred.

Here, the US dollar index has just barely overshot the lower part of its trend channel. As such, this is a critical moment for the greenback. If there is continuation or follow-through on the downside, then it is highly likely that the trend upward from the 1995 lows has been broken and a secular (that is, long term or even historical in some instances) bear market of declining or flat prices should follow. However, should the US dollar index rebound from the lower end of the trend channel line and move back into the channel, it is quite possible that prices will — over the next year or two — move higher, eventually testing the upper end of the trend channel.


One final technical view that is supportive of a greenback bull market is one based on an Elliott wave count. While there are many who remain unimpressed with Elliott wave methodology, I suspect that in the context of the 50% retracement, trend channel action, and some of the fundamental factors already mentioned, the conclusions reached by an Elliott wave analysis of the dollar's secular bull market from 1995 may seem much less far-fetched.

I won't go too deeply into Elliott wave methodology — which is a dangerous disclaimer on my part, I admit. Elliott wave analysis can become quite complex to the uninitiated, and even those who have studied the work of R.N. Elliott, Hamilton Bolton, A.J. Frost, and Robert Prechter for years occasionally disagree over wave counts — disagreements that often can only be settled by the passage of time and the continued movement of prices.

That said, Elliott wave analysis, in its most basic form, presumes a five-wave pattern in a bull market from trough to peak, with smaller five-wave patterns within each upward wave (1,3, and 5) and smaller three-wave patterns (a, b, and c) within each downward wave (2 and 4). Elliott wave analysis further presumes a three-wave pattern in a corrective bear market that follows the bull market, as noted. This three-wave bear market typically is built around a 5-3-5 pattern in which the first and third legs down (labeled "a" and "c," respectively) include a smaller five-wave pattern, while the second leg consists of a smaller three-wave pattern.

Figure 3: An Elliott wave count of the US dollar index since 1992 suggests that another rally in the greenback could be right around the corner.

This view and wave count of the dollar — represented here by the US dollar index — is predicated on the larger and longer-term wave count provided by Elliott Wave International in Prechter's 1995 text, At The Crest Of The Tidal Wave. This longer-term wave count begins with the decline of the dollar beginning in 1930 and, as such, represents an A-B-C correction of the historical bull market of the dollar (or, perhaps more accurately, "American" currency in general), since the first American money was created as early as 1690. Figure 3 presents the final three waves of the A wave of that A-B-C correction: the decline from the mid-1980s high (a high that represented the dollar's greatest value since the closing of the gold window in 1971), the dollar's rally in the wake of the crash of 1987, and the dollar's retreat during the economic contraction and subsequent mild inflation of the late 1980s and early 1990s.

This first five-wave pattern complete, the Elliottician would then look for a three-wave, largely countertrend A-B-C pattern. I believe the first A wave began with the dollar's lows in 1995 and ended with the dollar's peak in 2001 of about 121 on the US dollar index. The second B wave in this pattern is where the dollar market finds itself early in 2003, having fallen some 18% from its 2001 high. If the standard A-B-C correction does unfold, then a rebound from the current levels in the dollar should begin over the next few months, a rebound that could easily test the highs set by the peak of the A wave.

If the higher band of the trend channel mentioned earlier marks the peak of wave A and the lower band marks the trough of wave B, then just such a strong rally in the dollar — one that moves toward the upper band of a still-rising trend channel — should not be unexpected. Because the trend channel would still be rising at that point, it should also not be surprising if the peak of wave C actually exceeds the peak of wave A, perhaps even testing the highs of the dollar set in the mid-1980s.

I should hasten to add that A-B-C corrections can take myriad forms — too many to note here — and that any failure of a wave C to reach the upper band of the trend channel need not necessarily invalidate the correction process. In fact, when the C wave stops climbing and begins to reverse, it would then present a strong indication that the dollar deflation period was over and an extended period of dollar devaluation might indeed be underway. As Prechter noted in 1995 in At The Crest Of The Tidal Wave:

The history of politically managed paper currencies suggests little chance of avoiding the ultimate destruction of the dollar. There are countless examples of currency hyperinflation, so it would be prudent to be aware of what political forces typically impact a currency following several years of severe deflation. Because deflation devastates financial markets and the economy, the populace often demands a solution. One option is to return to a state of fiscal stability based upon a system of sound money, i.e., gold. Indeed, that decision is recurrently forced upon human beings regardless of their efforts to avoid it. If that path is not chosen, however, the threat of hyperinflation will loom large. If politicians decide to "get the country moving again" via currency inflation, the monetary trend will not simply reverse, but reverse dramatically.

David Penn may be reached at


Bernanke, Ben [2002]. "Deflation: Making Sure 'It' Doesn't Happen Here." Remarks before the National Economists Club, Washington, DC.

Murphy, John J. [1986]. Technical Analysis Of The Futures Markets, New York Institute of Finance/Prentice-Hall.

Prechter, Robert R. [1995]. At The Crest Of The Tidal Wave, John Wiley & Sons.

Charts courtesy of MetaStock

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