How much further will the Dollar decline?

FX:

Gold is on fire and the dollar is tanking this morning. But you probably already knew that. Last week we closed out all our positions to avoid year end volatility and make things simple for the accountants.

Recall that last Monday we said to look for a final rally in "wave 1" to cap a "five wave" advance from the December lows at 89.50. The dollar then broke below trendline support from those lows yesterday and we said "The dollar still looks like it completed a "five wave" move and is in need of a correction lower in "wave 2" before "wave 3" up gets underway." (See first two charts below for the prediction and the forecasted pullback today - which is why we stood aside yesterday).

The dollar index looks like a steep "wave 2" correction, and part of the reason is the FOMC minutes out later today which may show a path to the end of the rate hiking cycle. Recall that the December lows reached a nadir on the Fed's rewording of the announcement, but the dollar staged a dramatic comeback. This may be some of the same "Buy the rumor, sell the fact" action.

BUT, the one monkey in the works is the euro. Readers may recall our report from last week showing how the euro was looking much more strong than out favorite dollar short candidates like CHF.

There is a very obvious downtrend resistance line crossing overhead at 1.1970. A sideways move this week would be all it takes to break it. We point this out because EUR makes up the bulk of the dollar index and would therefore stand to alter our wave count.

So readers may recall that we were looking to reposition long USD/CHF on the first real trading day of the year (today). But with the possibility that EUR/USD breaches the key 1.20 level we must stand aside and allow the market to show us what it wants to do.

Another interesting comment on this is that John Netto, our friend, colleague and investment partner discussed with us last week that he was buying out of the money call options on EUR/USD. His discussion of the rational can be found here.

When he presented his strategy to us last week we agreed that a breach of 1.20 would likely lead to a flurry of buying making the 'cheap' out of the money calls a good bet. If you are long USD and worried about that exposure, one way to mitigate any further downside risk would be to follow Mr. Netto's lead.

That said, we are still looking to buy into any weakness in the coming days in anticipation of a rally to our initial target level of 95/100. But the steep selloff this morning obviously makes us extremely cautious and are therefore taking a seat and waiting for the minutes like the rest of the market to see if we should step in and buy. Recall that we bought USD/CHF three weeks ago at 1.2810 in the midst of the post-Fed dollar selloff. So today's action does not frighten us, it just warrants caution.

The bottom chart shows the same key level we were aware of three weeks ago when we recommended buying USDX. We think a recovery to back above the key 90.50 level this week would be the first sign that the dollar was regaining its footing. Obviously A MOVE BELOW THE "KEY" LEVEL in chart 3 calls for a much larger decline.

Gold's ongoing rally is testament to the changing dynamics of this market. We correctly called a top last year, but have struggled to feel confident this year about 'normal' retracement targets. As we said last week, if you are bullish on gold and are also holding long USD positions a good hedge right now is to start scaling into long AUD/USD around 0.73 due to what we think is the need for a strong bounce in Aussie. Last week we said we are going to wait to buy in our target range in 0.7150/0.68 early this year. But if EUR/USD breaks above 1.20 we think the most prudent course of action would be to buy AUD/USD and then wait for the selloff in USD/CHF to end before jumping into long USD positions again.

Stocks:

No change: Stocks are looking weaker and the "five wave" move down we want to see is getting there. A major stock market top coincident with an inverted yield curve should cause some concern from the bulls. Meanwhile, global equity markets are in need of a correction as well after some of our favorite markets made +40% in 2005.

Bonds:

No change: The corrective move in yields looks finished and as we said yesterday, "with the yield curve inverting we think the Fed should try to push the long end of the curve (with words of course) higher."

A seemingly dumb move would be to act as if the yield curve doesn't matter. We wouldn't put it past these guys to start saying this, and it would only strike intelligent people as absurd considering the Fed came out with a study after the 2000 market crash saying the surest sign of a recession was an inverted yield curve.

Never believe the phrase, "This time its different." As such we'd counsel them to talk up long term rates instead of acting as if the US/Global financial system is in perfect running order.

Regards,
Jes Black

FX Money Trends
613 4th St Suite 505
Hoboken, NJ 07030
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Jes Black is the fund manager at Black Flag Capital Partners and Chairman of the firm’s Investment Committee, which oversees research, investment and trading strategies. You can find out more about Jes at BlackFlagForex.com.

Prior to organizing the hedge fund he was hired by MG Financial Group to help run their flagship news and analysis department, Forexnews.com. After four years as a senior currency strategist he went on to found FxMoneyTrends.com - a research firm catering to professional traders.

Jes Black's opinions are often featured in the Wall Street Journal, Barrons, Financial Times and Reuters. He has also written numerous strategy pieces for Futures magazine and regularly attends industry conferences to speak about the currency markets.