Just eight or nine years ago, currencies were the hot-ticket item in the investment world. That was when central bank easy-money policies helped investors realize (and exploit) the interconnectedness of global economies and financial markets.
It was also pretty easy to bet against the U.S. dollar, too.
But then the financial crisis hit.
Then the greenback became the recipient of safe-haven capital flows. At the same time, emerging-market currencies, commodity dollars and the more-popular-than-ever euro were hung out to dry.
Just like that, the currency game got real.
Investors Cash out of the Currency Game
Newbies hadn’t realized the intricacies of the foreign exchange market. Their orientation was made painful by the financial crisis, and investors quickly lost their appetite for currency investments.
Currencies are back in the headlines this year, but not because investors are excited about them.
Rather, because China is battling renminbi valuation. On top of that, emerging markets’ dollar-denominated debt has become costlier because their currencies have lost so much value so quickly.
Regardless of whether currencies are hot or cold with investors and traders, the foreign exchange market still trades and currencies offer returns … if you choose pay attention.
Greenback: Going Higher
Starting here at home, I think the U.S. dollar has greater upside potential in the coming months and maybe even years.
Why? Because the U.S. is a relatively attractive destination for investment capital.
Barring a financial crisis that will shake the entire globe, the U.S. economy is more stable than most emerging markets, China and even many developed European nations. That could draw more foreign money to U.S. shores.
It’s what helped the dollar to gain so much value in 2014.
When this money makes its way to the U.S., those euros, pounds, yen and rubles are exchanged for dollars.
Included in that narrative will be investors’ expectations for U.S. interest rates. It’s never as simple as it seems, but monetary conditions are likely to tighten in the U.S. before conditions tighten in major economic counterparts such as Europe, Japan and China.
This tightening matters to investors so long as the yield differential — the difference between U.S. yields and its counterparts — is improving.
It means investors can earn more money by parking cash in U.S. dollar-based assets than yen- or euro-based assets, for example.
This underpins my longer-term bullish bias for the U.S. dollar.
It’s important to keep in mind, however, I think the buck’s major hurdle is itself.
Earlier this year, much concern emerged about the influence a strong U.S. dollar had on U.S. exports and, thus, the trade deficit.
So everyone figured the Federal Reserve would pare back its plan to hike interest rates several times this year.
Dollar weakness ensued, and the buck is just now finding its footing again.
The three-wave consolidation suggests we could see a pretty considerable extension of the 2014 rally.
That chart above shows my preferred price setup for the U.S. dollar. The price is for the U.S. Dollar Index, which is an uneven basket made up of six foreign currencies.
Euro (EUR), 57.6% weight
Japanese yen (JPY) 13.6% weight
Pound sterling (GBP), 11.9% weight
Canadian dollar (CAD), 9.1% weight
Swedish krona (SEK), 4.2% weight
Swiss franc (CHF) 3.6% weight
For those looking to invest in the U.S. Dollar Index, there are vehicles out there for that.
Or you can also bet on how the dollar will fare against any single currency.
The euro, interestingly, has assumed a sort of carry trade role at times. It’s the role to which the U.S. dollar laid claim until early 2014. Before that, the Japanese yen was the notorious carry trade currency.
The euro is more than that, though.
Since emerging from the latest Greek charade, Europe has mostly stabilized and investor confidence in the euro area has improved.
Importantly, the European Central Bank has committed to a policy of ongoing monetary accommodation to ensure the economic recovery is not smothered.
In one sense, the ECB’s policy is bullish for the euro zone and thereby supportive of the euro. But in another sense, it undermines the euro’s yield relative to the U.S. dollar.
That’s because the Federal Reserve is expected to hike rates sooner than the ECB, suggesting more favorable yields in the U.S. than in the euro zone for the foreseeable future.
Precisely the opposite of my technical outlook for the U.S. dollar, I think the euro could extend its sell-off after this three-wave consolidation.
Substantial downside may be unlikely, however, since the euro has lost so much value since the 2008 financial crisis and amid its own economic struggles.
Indeed, things are stabilizing (on a relative basis) in the euro zone, and the selling pressure on its currency might not sink much below par.
Inflation is mostly absent in the developed world. Notably stagnant are U.S. wages. And falling commodity prices sure didn’t provide much upward price pressure.
So one might just assume Japan is continuing with where its lost decade left off.
And one might be right.
The Bank of Japan is very much in the same position as the European Central Bank — the same position from which the U.S. Federal Reserve has been hoping to depart — providing monetary accommodation to its economy.
Ultimately, this yield differential dynamic will power the yen lower vs. the U.S. dollar.
The chart above shows the USD/JPY exchange rate. Falling prices indicate U.S. dollar weakness, and Japanese yen strength.
After a three-wave move that drove money into Japan and strengthened the yen, it appears a period of dollar strength (yen weakness) is in order.
Until this year, commodities were pummeled. It’s because China began feeling the effects of an economic hangover despite all their efforts with the hair of the dog.
The pain in commodity investments tied to China has been well-documented.
Less documented, but entirely relevant, was been the assault on the Australian dollar.
The Aussie is considered a commodity dollar because Australia is blessed with natural resources. Its economy is very much contingent upon the trade of its commodities and natural resources.
So, the value of its currency fell in kind.
Central bank expectations played a role last year. And they’re playing a role again now …
The Reserve Bank of Australia has been cutting or keeping rates low to alleviate commodity price pressures on its economy.
The Australian dollar lost 35% of its value from the first half of 2013 to the end of 2015.
A recent rebound in commodities and a breather from the RBA helped the Australian dollar to recover 14% from January to April of this year.
But then, in the latest meeting, the Reserve Bank of Australia cut rates — surprising the market by taking the benchmark rate below 2% in order to help generate inflation and fight back against the deflationary/disinflationary pressures emanating from China.
That applied pressure to the Australian dollar.
But it would seem that pressure will soon subside as investors realize China will continue to stimulate its economy with debt and maintain a decent level of commodity demand.
Want to play these currencies?
You can trade the U.S. Dollar Index with the PowerShares DB U.S. Dollar Bullish ETF (UUP).
For the euro, yen and Australian dollar, you can use the CurrencyShares exchange-traded products: the euro ETF (FXE), Japanese yen ETF (FXY) and Australian dollar ETF (FXA).
If you want to play for the euro and yen to decline, there are inverse ETFs with double leverage available … so you don’t need to “sell short” the CurrencyShares ETFs.
The leveraged inverse ETFs are the ProShares UltraShort Yen (YCS) and the ProShares UltraShort Euro (EUO). Each of those ETFs rise in value twice as fast as their respective underlying currencies fall in value.
Shorter-term investors may consider using options on the ETFs I mentioned to capture sizeable returns in a short amount of time.
P.S. The last time the currency markets heated up like we’re seeing today, the "Quantum Compounder" trading system handed a select group of readers 32 different opportunities to make money (including split trades) in just 12 months. And late last week, this system alerted us to a unique way to play the dollar’s next move. You can still get in on this brand-new trade idea — start by clicking here.