Investing & Trading

While the factors affecting gold are no doubt nuanced, its popularity is primarily vested in the belief that it represents a stable alternative to the Dollar. Accordingly, as the Dollar fell over the last five years, gold prices soared. Likewise, the ongoing Dollar rally has been matched by a proportional decline in gold prices. However, at least one analyst believes this link could soon break down. While gold is traditionally viewed as a specific protection against US inflation (and the concomitant Dollar depreciation), perhaps its role could expand to offer protection against worldwide inflation.

John Taylor is head of the world's largest currency hedge fund, International Foreign Exchange Concepts. Accordingly, when he speaks about currencies, people tend to listen. In an extended interview with Bloomberg News, Taylor noted that volatility has surged in the forex markets. On average, the Dollar is fluctuating 46% more against so-called major currencies and 23% more than emerging currencies, compared to 2007. However, this volatility is largely random- perhaps as a result of increased liquidity- which means inefficiencies in the markets are becoming harder to exploit and profit from. One of the fund's largest bets is against the US Dollar, specifically against the Euro.

Over the last few years, the inverse relationship between the price of oil and the value of the US Dollar has been remarkable. As the Dollar has fallen to record lows, oil has risen to record highs. Now, with a massive Dollar rally underway, the price of oil has virtually collapsed. This relationship is understandable, since expensive oil contributes to the US trade deficit and crimps the economy, while the weaker Dollar, in turn, drives oil-producing countries to charge more in Dollar terms for their oil so that the price remains constant in absolute terms.

Yesterday, the Forex Blog published a commentary piece exploring the rally in the Dollar that is currently under way. While the rally is strongly grounded in fundamentals (falling commodity prices, the spread of the credit crisis to the rest of the world), some traders are nonetheless crying foul. They claim that the European Central Bank (with or without the assistance of the US) furtively intervened in forex markets to the tune of 10 Billion Euros. Even if their claim is true, it is unlikely to have meaningfully contributed to the Dollar rally, since the amount in question is quite small. Central Bank intervention would require an expenditure of at least $100 Billion to be even partially successful.

The USD is officially trending upwards, having appreciated over 7% against the Euro in only a few weeks. Of course, hindsight is 20/20, and some analysts now claim that support for the Dollar had been building for several months. They point out that the first break for the Greenback came in March when the Fed stopped lowering interest rates. Then, at a meeting of the G8 nations, several high-ranking officials indicated that they were unhappy with the recent decline of the Dollar and suggested that coordinated intervention should be effected in order to prevent a further collapse of confidence. While this "verbal intervention" was ultimately not backed by any kind of substantive action, investors apparently took the hint.

As the credit crisis has unfolded, the Dollar has remained (relatively) strong, especially considering the deteriorating state of its economy. The reason for this, of course, is that in times of crisis, investors flock to perceived safe havens, such as the US and EU. However, an especially pessimistic series of economic developments has called into question the wiseness of this strategy. A handful of American banks and mortgage institutions have already collapsed, and bankruptcies in all sectors of the economy will surely become more common. The picture in Europe is equally bleak. Several economic indicators have fallen to multi-year lows, and the ECB's decision to hike rates looks increasingly misguided. Given these circumstances, where can investors turn?

Earlier in the week, the Forex Blog reported that the potential for intervention in the forex markets seemed to have declined, due to a brief Dollar rally and toned-down rhetoric at the most recent G8 conference. However, we would be remiss if we didn't point out that the intellectual justification for intervention remains. While statistics have not been forthcoming, it appears that Sovereign Wealth Funds and Central Banks are paring their exposure to Dollar assets, which is both a cause and effect of Dollar weakness. In addition, the falling Dollar and rising oil prices have reinforced each other, and contributed to surging inflation around the world. Investment Banks are advising clients now would be a perfect time for the world's economic policymakers to take coordinated action.

Typically, only the savviest (or the most foolish) of forex traders dabble in currency options. Leverage is already so high (often exceeding 100:1) when trading forex directly, that the additional leverage gained from trading options can seem unnecessary. However, even if not trading options, you would be wise to at least pay heed to options prices. The reason is that movements in the options market often precedes movements in the forex markets.

Over the last few months, the Dollar has bounced up and down against the Euro, but never breaking out of a range defined by $1.53 and $1.60. Analysts remain divided not only over if the Dollar will soon break-out, but also over whether its next major move will be upwards or downwards. The recent Dollar upswing has led some to speculate that more permanent strength is inevitable, but naysayers note that this rebound was a product of lowered oil prices, caused by global economic weakness, which is actually Dollar-negative. According to a recent poll, though, the bulls outnumber the bears; the consensus forecast for the Dollar 12 months from now is $1.50. The Wall Street Journal reports:

Without exception, every time there is a period of sustained volatility in forex markets, a flood of new forex accounts are opened as new traders try to capitalize on the action.  Also, without fail, a concerned journalist inevitably takes it upon himself to warn these would-be profiteers that trading forex is risky, as if that were not abundantly obvious. This past week is a perfect example, as the Dollar touched a record low against the Euro on the basis of credit concerns. One columnist pointed out the significant upside potential of purchasing a CD denominated in foreign currency, but also implored investors to hedge their exposure and limit leverage.