EURO FALLS ON HINT ECB MAY BE READY TO LOWER RATES -- THAT SHOULD HELP THE DOLLAR WHICH IS IN A MAJOR OVERSOLD CONDITION -- A DOLLAR RALLY WOULD HELP MAKE US STOCKS A BETTER VALUE THAN FOREIGN STOCKS -- COMMODITIES MAY ALSO PULL BACK IN A DOLLAR RALLY

EURO FALLS ON ECB WILLINGNESS TO LOWER RATES ... My article on Tuesday about the likelihood that the ECB would have to start lowering rates pretty soon elicited a lot of questions about the implications of such a move. I'll try to address some of them here. Two rate decisions were made in Europe this morning. The Brits lowered short-term rates by a quarter of a point for the second time in three months (as they were expected to do). That weakened the British Pound further (Chart 1), which has now fallen to the lowest level since last spring. The pound peaked in November in anticipation of that move (as markets usually do). The ECB held Euro rates unchanged at a six-year high of 4%. More importantly, its president signalled that he's open to cutting Euro rates for the first time in almost five years. Naturally, the Euro is starting to fall in anticipation of that inevitable easing. Today's 1% fall against the dollar puts the Euro even further below its 50-day average and in danger of forming a double (or even triple) top near 1.49. That raises the inevitable question about the fate of the U.S. dollar, and the implications of a possible rebound in the greenback.

Chart 1

Chart 2

DOLLAR COULD BE BOTTOMING ... The daily chart of the U.S. Dollar Index is a mirror image of the Euro. The USD has bounced off support near its November low and has risen back over its 50-day moving average. That sets up a possible "double bottom" in the making. For that to actually happen, the USD still needs to clear its December peak just below 78. One of the reasons the dollar has been so weak has been the perception that the U.S. economy is weaker that the rest of the world. It was assumed that the Fed would have to start lowering short-term rates to prevent a U.S. recession (which they did last August). It was further assumed that foreign markets would be relatively immune to U.S. problems, and would be able to keep their rates steady and their currencies firm. The new realization of "economic recoupling" means that foreign central bankers will have to start lowering rates soon to combat their own economic problems. That process is being sped up by the recent fall in foreign stock markets. Since markets discount the future, the Euro (which has the biggest influence on the dollar), has already started falling. The Fed is at least six months ahead of the ECB in lowering rates. That means that foreign bankers will have to start playing catch-up to the Fed. That should work against foreign currencies and in favor of the dollar.

Chart 3

WEEKLY DOLLAR INDICATORS TURN UP... Chart 4 shows that the Dollar Index is still in a major downtrend. At the same time, it looks very oversold and ripe for a rebound. We're not necessarily talking about a major bottom here, but one of intermediate-term proportions. The two weekly indicators are encouraging. The 14-week RSI is moving up from oversold territory below 30. The weekly MACD lines have turned positive. If the USD were to exceed its December peak near 78 (the minimum requirement for a bottom), it could rally back to its late 2004 low near 80 (5% above current levels). The three green lines show Fibonacci retracements from the late 2005 peak to the late 2007 bottom. A 38% to 50% retracement could carry the USD to the 81-83.00 zone (which would still be within the confines of a long-term downtrend). A rally to the top of that range would mean a price appreciation of 9% from the current price.

Chart 4

MONTHLY CHART SHOWS MAJOR OVERSOLD CONDITION ... The monthly bars in Chart 5 show the Dollar Index trading near a record low. Within that bearish context, however, monthly momentum indicators show a deeply oversold dollar. The 14-month RSI line (overlaid on price bars) is bouncing from oversold territory below 30. In so doing, it is forming a "positive divergence" with the USD price that fell to a record low during 2007. [A positive divergence exists when price falls to a new low and the RSI doesn't, especially when it's below 30]. Chart 6 uses monthly Bollinger bands to show how far a dollar rally could carry. The first major upside target is the 20-month average (middle dashed line), which currently sits at 81.25. That's an important resistance barrier. A move over that line would suggest a further rally to the upper band, which currently sits near 88. Even that would still be within the confines of a major dollar downtrend. Here again, we're not calling for a major dollar bottom. We are saying, however, that the dollar decline appears overdone and the greenback due for a meaningful rebound. What should trigger that is the impending round of lower rates by foreign central bankers.

Chart 5

Chart 6

US SHOWING BETTER RELATIVE STRENGTH ... I've been making the point that foreign markets have started falling faster than the U.S. over the past two months. The good news is that the U.S. is starting to show better global relative strength for the first time in a long time. Chart 7 is a ratio of the S&P 500 divided by EAFE iShares, which has risen to the highest level in five months. That in itself isn't enough to suggest that the six-year period of US underperformance is over. Momentum indicators, however, are suggesting that it might be. Chart 8 applies two weekly momentum indicators to the SPX/EFA ratio. The 14-week RSI line is close to reaching the highest level in three years. The 12-week Rate of Change (ROC) line (below chart) is doing the same. The ability of both momentum indicators to do that suggests that the rebound in US relative strength may have staying power. The reasoning seems to be that with the Fed ahead of the rest of the world in monetary easing, the U.S. may be further ahead in the slowing process and, as a result, in the healing process as well. Chart 9 shows that the period of U.S. underperformance (falling S&P/EAFE ratio) coincided with the major peak in the U.S. Dollar in 2002 (green arrow). That being the case, a firmer dollar could start working in favor of the U.S. market relative to foreign markets.

Chart 7

Chart 8

Chart 9

DOLLAR RALLY COULD STALL COMMODITIES ... Another potential side-effect of a dollar rally could be a corresponding pullback in commodity markets. That's because commodities generally trend in the opposite direction of the dollar. Chart 10 shows that the major bull market in the CRB Index began during 2002 as the dollar was peaking. A dollar rebound, therefore, could lead to some profit-taking in commodity markets. Here again, we're not necessarily talking about major trend changes. We're simply talking about corrections to current trends (a rebound in the dollar and a correction in commodities). A commodity pullback is also consistent with a period of global economic slowing.

Chart 10

NOT ALL COMMODITIES ARE EQUAL ... Some commodities are more vulnerable than others. I refer you back to a Market Message that I posted on January 17 entitled: "Yes, Commodities Do Pull Back During a Recession -- Copper Is The Most Vulnerable While Grains Are the Least Vulnerable -- Gold Should Hold Up Better Than Oil In a Falling Economy". One of the reason gold holds up better than oil is because gold benefits as an alternative to stocks. That message also suggested that gold is preferable to oil in a weakening economy and falling interest rates. That doesn't mean that gold won't pull back if the dollar rallies. But it should still hold up better than energy and industrial metals. Chart 11 is an updated version of a chart I showed on January 17. It plots a ratio of gold versus oil (using their corresponding ETFs). The chart shows that gold has been doing much better than oil since last November. Chart 12 compares the performance of the four main commodity groups since midyear. All are plotted relative to the CRB Index which is the flat black line. Industrial metals have been the weakest by far reflecting weak economic growth. Agriculturals (blue line) remain the strongest. Precious metals (red line) are second in relative strength. The falling green line since November shows weakness in Energy, which is also being hurt by economic slowing.

Chart 11

Chart 12