The Dollar:

The Other Technical Indicator?

By Steven Poser

In the world of the stock, bond and currency markets, there are absolutely no constants.

I have sat on bond trading desks, foreign exchange (FX) trading desks and equity hedge fund trading desks. Everybody has an opinion on the relationships between stocks, bonds, currencies and commodities. Books have been written on the subject. The only constant is that there is no constant. But that’s a hard reality for some market participants to swallow.

As a technical analyst with a degree in economics, I have always been amazed at how fundamentally driven types spew commentary about how a movement in U.S. interest rates means that something has to happen to the U.S. dollar or the U.S. stock market. Such assessments imply that there is in fact a constant between markets. However, they often ignore rates in the country on the other side of the exchange rate – yet exchange rates are fundamentally driven by interest rates in two countries. So much for constants.

Timing the relationship between any two markets is a tenuous endeavor, but it is especially difficult when one of those markets is foreign exchange. Consider some of the conclusions served up by market analysts and media. Sometimes they declare that a week dollar is good for U.S. stocks because exporters can sell their goods in other countries for less money relative to the competition. Of course, what is good for exporters is bad for importers. Given that the U.S. imports more than it exports, it would stand to reason that a stronger dollar should be, on net, good for U.S. equities.

On the other hand, the analysts and media sometimes conclude that a strong dollar is essentially hurting U.S. stocks because American imports cost so much. If this is in fact the case, then our trading partners should see the opposite – relatively stronger stock markets. Look at the past year: strong U.S. dollar, huge U.S. current account deficit and a neutral stock market in contrast to much stronger foreign equity. With differing possible outcomes in the dollar stock/bond relationship, people may simply throw up their hands and believe that there is no relationship at all. This would be wrong as well.

Turn to Technicals

Unfortunately, economists do not live in the real world. (Many of my best friends are economists, so please be careful not to hit them too hard with this reality, as it could hurt them.) We simply do not always know how people will interpret the fundamental data and exactly when any given change in one market will affect another market. This is the reason I much prefer using technical analysis when making decisions on how to allocate funds based on intermarket analysis.

Why technical analysis? That is quite simple. An analyst can give you a valid fundamental argument for the direction of stocks, bonds or currencies for virtually any relationship. The time it takes between market cycle turns varies greatly. By stepping back and just reviewing the facts, such as price movement, without preconceived notions, you can discover the timing of the relationships and act on them. Also, if these relationships change, you will quickly see it as your system turns less profitable.

Diamond in the Rough

The remainder of this article covers a strategy that uses Dow Jones Industrials Average (DJIA) via the Dow Diamonds (DIA) exchange-traded fund (ETF) and uses the dollar to indicate when to take buy and sell signals in the stock market. DIA essentially mimics the DJIA by owning all of the stocks in the venerable index in the same relative quantities as they are held in the index itself. The measure of the dollar is the Federal Reserve's broad trade-weighted dollar index. This strategy employs a trade-weighted index because it more fairly represents the fundamental cause-and-effect relationships that we are implicitly trying to measure when making investing decisions based on exchange rates and stock markets. (For an explanation of how the index is constructed, see http://www.federalreserve.gov/pubs/bulletin/2005/winter05_index.pdf.) Table 1 shows the current weighting of the index. Of course other dollar indexes may be used for different means, The New York Board of Trade’s U.S. dollar index (USDX)

 TABLE 1: Current Weighting of the Index

Economy         Current Weight

Euro area:         18.80%

Canada:            16.49%

China:               11.35%

Japan:               10.58%

Mexico:            10.04%

has a 57.6% weighting in the euro and does not even include the Chinese or Mexican currencies. Using the USDX can be a convenient hedging tool in futures or even via the New York Stock Exchange-traded Euro CurrencyShares ™ (FXE), because the euro is such a heavy weighting.

You may even consider testing any system using the USDX, the euro, yen, Canadian dollar or any other exchange rate or create your own index by weighting the index via a testing regime. You could also buy and sell baskets of U.S. exporters and importers based on a constructed index using the export and import weightings of the U.S. economy with other currency regimes.

Testing Relationships

For our purposes of this article, the fundamental premise is that the U.S. economy tends to import more than it exports. Therefore, a stronger U.S. dollar should be relatively better for the stock market.

Figure 1 shows a largely positive relationship between stocks and the dollar. Whenever the Fed Trade-weighted dollar index crosses above its ten-month moving average, then follow Dow buy signals and go into cash if the Dow crosses below its ten-month moving average. Likewise, if the Fed Trade-weighted dollar index crosses below its ten-month moving average, then stay in cash when the Dow is above its moving average and sell short when it moves below. The idea here is that, if the dollar and the Dow are moving counter to each other, the trends are not sustainable and you are more likely to see whipsaws.

As previously noted, you can use the DIA ETF as a proxy for the Dow. You might also want to test this system with the Nasdaq-100 Composite (QQQQ), S&P 500 SPDRS (SPY) or the Russell-2000 iShares (IWM).

Another possible application would be, for example, to devise a similar strategy using the Japan MSCI iShares (EWJ) with a trade-weighted yen index. You would need to hedge the currency exposure, though, because Japan is export driven, and a gain in the yen would theoretically be bad for the Japanese stock market.

FIGURE 1: Sticking Together: The Dow and the Fed Trade-Weighted Dollar Index

Source: Data from the Federal Reserve

FIGURE 2: Rate of Change USD/Yuan

Source: www.TradingEducation.com based on data from the Federal Reserve and Dow Jones

Possibly the single most interesting play may involve the Chinese stock market. Speculation has run rampant for years about whether or when China would allow its currency, the yuan, to float freely. Near-constant political pressure has weighted on China to let the yuan float. Many market participants expect a huge surge in the yuan against the US dollar, due to America’s enormous trade deficit with the People’s Republic. According to a paper by the Federal Reserve Bank of San Francisco, the U.S. represents approximately 20 percent of China's trade, if you include its 15 largest partners, plus Hong Kong.

As I’ve said, I am always leery of what economists have to say. Everybody expects the yuan to appreciate because China has a huge trade surplus with America. According to the Congressional Research Service in its January 2006 updated report, China claims to have a trade deficit with Japan (although Japan suggests otherwise). Given the large direct investment flows into China and the risk if the currency is completely liberalized that substantial flows could also exit China, there is no guarantee that these flows would prevent a very sharp rise in the currency. Because China so heavily depends on exports to the U.S., a huge rise in the yuan would like hurt its stock market. However, a steady or expected decline probably will not be a major hindrance.

You can easily own the Chinese stock market via the iShares FTSE/Xinhua China 25 Index Fund (FXI). But what would you use as your proxy for deciding whether or not to own FXI? A simple moving average may not be good enough. Most market participants do expect the yuan to appreciate over time versus the dollar. This is a good thing for a U.S.-dollar based investor, as it would help balance any drop in the Chinese stock market. Still, be on the lookout for a sharp appreciation in the yuan. Instead of looking for a 200-day crossover in the moving average to yuan strength, you may want to look for a crossover of the 200-day moving average to yuan strength, you may want to look for a crossover of the 200-day moving average of the 10-day rate of change. (See Figure 2.) This would allow you to exit your long FXI position if the yuan started to appreciate more quickly than before.

Effectively Using The Dollar As An Indicator

Regardless of exactly which investment you plan to applying these methodology to, you must understand trade flows, and what makes stocks and currencies move. You must also be prepared to change your rules if trade factors change. For example, if China became a net importer, you might want to be long the Chinese stock when its exchange rate strengthens. Either way, an intelligent combination of fundamental knowledge, technical analysis techniques should allow you to make more money than using either tool on its own.

Steven Poser is an educational consultant to www.TradingEducation.com, author of Applying Elliott Wave Theory Profitably and a member of the Board of Directors of the Market Technicians Association.

Reprinted from SFO Magazine
Copyright © 2006 SFO Magazine
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