Expect a Short-Term Pullback in the US Dollar but Longer-Term Strength
The recent dip in the markets coincided with significant dollar short-covering–and hence dollar strength. Asking which caused the other is somewhat akin to asking the classic chicken and egg problem. Nonethless, by digging deeper into the technicals, the commitment of traders, and just common sense economics, it is easy to see (strangely this view is unconventional) why the dollar will be strong for the coming year. In the short-term however, the dollar is bouncing off of oversold conditions, and momentum and acceleration are waning. The commercials in the US dollar index are currently holding a very low level of positions which is generally a bearish sign since they are contrarian. The recent move by Australia (with Canada soon to follow) to hike interest rates will only create more temporary demand for the carry trade—borrowing in US dollars to buy Aussie dollars—and I would expect short-term Aussie strength. Note you can buy FXA which is the CurrencyShares ETF which tracks this index–or you do the much more lucrative trade of leveraging up by shorting dollars vs the aussie currency at generate a spread of 3.75% (try that at 100 to 1 leverage!).
With the market currently showing some bullish momentum and other risk-oriented sentiment indicators flashing green, the dollar is still holding up fairly well. This indicates that the short-term move in markets may last a few days, until a short-term dollar pullback would signal overexuberance. However, keep in mind that the 50-day moving average has recently crossed the 200-day on the dollar –ie the golden cross, which is a strong long-term signal. It is not wise to bet against this long-term trend -as those who shorted the market following the golden cross in the SPY learned the hard way. Further supporting the US dollar are the negative headwinds facing the Euro–with many constituent countries facing significant problems (including Greece) with currently no good policy responses. As the Chinese face significant inflation and choose to cool down their economy, at some point they will invariably entertain the prospect of currency revaluation versus the dollar. This would be desirable to both the US and China, and since the two governments are working together, this is not an unlikely outcome for 2010. I would be buying any decent pullback–looking for the 5-day moving average to cross below the 10-day moving average for a couple days with a low rsi2 value.