Why the Dollar Could Fall Another 5%-7%

11/12/2009 12:01 am EST

Focus: FOREX

Kathy Lien

Managing Director and Co-Founder BKForex LLC, BK Asset Management

As the US dollar continues to press lower against the euro and Australian dollar (the AUD/USD rose to a 15-month high) and US stocks reach new highs, many traders may be wondering how much further can the greenback fall. So far this year, the Euro has appreciated 7.50 percent against the dollar while the Aussie appreciated 32.5 percent.

Although these moves may seem large in the context of an average 1 percent move for each currency pair over the past three decades, there have been four years where the EUR/USD moved more than 20 percent in a single year and 15 years where the EUR/USD moved between 10 and 20 percent in one year. Interestingly enough for the AUD/USD, there has only been 14 times where the currency pair moved in excess of 10 percent.

The latest rally in the Aussie actually ranks right up there with the biggest move that we have seen in the currency pair over the past three decades, which was a 34 percent rally in 2003. Nevertheless, trends in the currency market can last far longer than most of us can anticipate, particularly given such a weak outlook for the US economy and the "dovishness" of the central bank. Last night, Federal Reserve President Fisher said, "there are too many retailers in the US and we could 'lose some.'" As we mentioned in our daily report last night, if these retailers shut their doors, expect more layoffs. Fisher also said point blank that "now is not the right time to tighten."

Like Treasury Secretary Geithner, Fed officials have no serious concerns about the fall in the US dollar. According to Fisher, "dollar depreciation is not disorderly." So the question becomes - How much further can the dollar fall?

In our opinion, the dollar could fall another 5 to 7 percent against the euro and Australian dollar. Reason being that the outlook for the US economy is not going to change on a dime, which means that the most realistic trigger for a bottom in the US dollar and a top in the euro or Aussie would be coordinated verbal intervention by foreign policy makers at a G7/G8 or G20 meeting. So far, the ECB has been comfortable with the rise in the euro but everyone has a breaking point. Another 7 percent rise in the EUR/USD would take the currency pair to 1.60, which is basically the record high. A 7 percent rally in the AUD/USD would take the currency pair to 0.9950, which is just shy of parity.

There is a very good chance that these will be stress points for foreign central banks since they have been in the past but verbal intervention could occur even before we reach those levels, somewhere between the 5 to 7 percent mark. We expect this to come in the form of harsh language from G20 policymakers. The following chart of the EUR/USD shows how changes to the foreign exchange language in the G7/G8 communique have previously triggered a top or bottom in the EUR/USD. Now that G20 leaders have made the G20 meeting more important than the G8, the FX language changes could come at either meeting. At some point, central banks will throw in the towel and say that they will no longer sit idly and watch the dollar fall.

Click to Enlarge

US Economy Could Also Determine Fate of Dollar

In yesterday's daily report, we also talked about two other cases where the dollar could change trend. In our opinion, these two situations are less likely than verbal intervention from the G20. The first would be a double dip recession in the US economy. The jobless rate in the US has exceeded 10 percent, and the fact that more companies are announcing layoffs means that unemployment may not have reached its peak. The difficult economic environment foreshadows a weak holiday shopping season that in turn could lead to more layoffs. Many retailers are banking on spending in November and December to stem their losses.

The US economy could handle a jobless recovery but a recovery without spending is not much of a recovery at all. The second scenario where the dollar could reverse its downtrend, would be if US growth accelerates beyond that of its peers. Given the current circumstances or even future circumstances, this is unlikely unless there is a sharp contraction in the Chinese economy or if the unwinding of monetary stimulus by other countries coupled with strong currencies start to take on toll on those economies.

Check out the EUR/USD chart below for a graphical indication of where we may be headed:

Click to Enlarge

By Kathy Lien of GFTForex.com

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