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The Dollar Rally: Parallels with the late-1980s

Below is an extract from a commentary originally posted at www.speculative-investor.com on 22nd May 2005:

In the commentary posted at TSI on 3rd January 2005 we outlined a number of reasons why we thought an intermediate-term rally in the US$ was about to begin. Chief among these reasons was the fact that interest rate differentials were trending in favour of the dollar, but we also pointed out the following secondary reasons to expect a substantial recovery in the dollar over the ensuing 6-12 months:

1. There was a massive speculative short position in the dollar that would have to be covered at some point

2. Legislation had recently been passed that would allow US corporations to repatriate profits earned outside the US at a greatly reduced tax rate for a period of one year

3. Current purchasing power and interest rate differentials indicated that the euro was about 20% over-valued relative to the US$

Lastly, we noted that it was simply TIME for a dollar rally because the downward move that had begun in earnest during the first quarter of 2002 was now 'long in the tooth' as far as uninterrupted downward trends were concerned. As part of this discussion we compared 2002-2004 with 1985-1987 and pointed out that during this prior period a relentless 3-year slide in the dollar (a relentless 3-year rally in the Swiss Franc) had ended on the last trading day of 1987. The following chart was included in our 3rd January commentary to illustrate the similarities between the Swiss Franc's trend during 1985-1987 and its trend during 2002-2004.

We are always skeptical of analysis based on the assumption that the market will behave the same way in the future as it did during some prior period, firstly because there are always plenty of fundamental differences between two periods that are separated by many years and secondly because markets just aren't that simple. However, we find it interesting that today's currency market continues to behave in a spookily similar manner to the currency market of the late-1980s. Furthermore, a continuation of the similar price action would be roughly in line with what our other analysis suggests is a likely pattern over the coming 12 months.

To illustrate how today's currency market appears to be following a similar path to the one followed by the same market during the late-1980s we've included, below, a chart comparing the Swiss Franc's performance over the two years beginning in July of 1987 with its performance beginning in July of 2004. Notice that:

a) The SF broke higher in both October of 1987 and October of 2004 and surged into year-end

b) After dropping into the first half of February (1988 and 2005) the SF consolidated for about 3 months

c) The consolidation ended via a sharp break to the downside in mid-May of both 1988 and 2005

If the similarities continue then the Swiss Franc will drop to much lower levels over the next 3 months, bottom during August-October, rally into December, and then decline to its ultimate correction low during the first half of next year.

Something along the lines described above would actually mesh with our expectations for other markets. In particular, we expect gold and gold stocks to bottom well before the dollar peaks so a peak in the dollar around the middle of next year would fit nicely with our forecast of a gold-sector bottom during October-November of this year. One probable scenario, for instance, would have gold stocks bottoming in October of 2005, rallying strongly into December along with a rebound in the Swiss Franc, and then consolidating for several months while the SF dropped to a new low.

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