We just finished setting up our remote office in Playa del Carmen, Mexico. Phew!

We apologize to those that are not subscribers for the lack of free reports during this time. Those of you that subscribe to our Head of the Trend newsletter service were kept up to date on the dollar's near term moves. And what a finish to the year the dollar is giving us!

With the year drawing to a close and the dollar poised to rally from January to July 2006 we thought we'd recap why we forecasted a strong rally for the dollar in 2005. Some readers may recall that we said dollar bears were "looking in the rear view mirror" if they thought we'd see a fourth consecutive year of decline.

In fact, we said buying dollars was possibly the "Best Trade of 2005." But that honor should go to gold as it surpassed our upside target of $480/$500. For commodity and currency traders alike this "anomaly" of dollar and gold strength is perhaps the most interesting development in markets for some time.

The explanation is really quite simple. As readers of our reports are aware, last year we showed a little known ratio that has a high degree of fit with the dollar index. Basically, we take the ratio of the 3-week TBill to 30-year yield. This shows us the market's expectation of short term interest rates in the US, which is the primary mover in currency markets. We said the market was predicting higher short term rates in the US and with Europe looking sickly, higher US rates would attract deposits.

With the upturn in interest rate expectations we said in December of 2004 that the time had come to start buying the dollar index because the market was projecting higher short term interest rates. But we only bought the dollar against the Swiss franc and Japanese yen (two components of the dollar index with the best interest rate advantage) while we also maintained long positions in certain key commodity currencies (AUD, MXN).

In currency trading you buy one currency and sell the other. Interest rates are a prime concern and so is value. With gold, there is no interest rate, but we feel that it is undervalued by at least 200-300 dollars. So gold represents a long term buy and hold asset. Even while the dollar rallied this year, we never once recommended shorting gold.

While gold is an "asset" play, currency trading/forecasting is really much more simple than commonly believed. Interest rates - not deficits, housing starts, Greenspan's briefcase - are the single main driver.

To make a simple analogy, would you prefer a checking account that paid you 2%, 4% or even 7% on your deposits, or would you prefer a checking account that charged you 2%, 4% or more?

Some analysts feel that paying 2-4% interest is a fine trade off for the scary trade deficit. But if you prefer collecting interest on your short term deposits, and can manage not listening to the economists, you might make a very good currency trader. As ludicrous and scary as the trade deficit is the TICS data keep showing strong interest in our assets.

In the following chart we show in greater detail just how integral short term interest rates are to foreign exchange rate dynamics. Below we show the ECB rate subtracted from the Fed funds rate (Fed-ECB=USD/EUR rate differential). The blue line over the left axis is what annual percentage rate the USD/EUR checking account paid you over the past six years.

As you can see, the USD/EUR checking account paid as much as 2.5% annualized on overnight deposits in 1999-2000 and cost you as much as 2% in November 2002. Again, this is represented by the Fed-ECB rate differential in blue (left axis is basis points in hundreds).

The orange lines show when the checking account crosses from interest bearing to interest charging. Currency traders, much to the dismay of media outlets, don't really care about much else. Note that when the Fed/ECB bank decided to stop paying us on our short term USD/EUR deposits, we withdrew money from the bank. When they decided to pay us, we poured money in again.

Our clients have seen chart after chart this year indicating why the dollar would rally in 2005. Longtime readers of our public reports may also recall that we even forecast that once the dollar did rally off the 80 support level in 2005 the media would shift its focus from the "trade deficit" to "interest rates." This is because it is the media's job to rationalize the moves for you. Wanting to be in the papers and on TV, many currency analysts simply ignore the real reason currencies trend and focus on the "She said, He said" of market noise. A contrarian armed with correct knowledge of currency dynamics can use this misinformation to his/her advantage.

In fact, the media's preoccupation with Fed wording last week was very, very misleading. As you can see from the chart above, the rate differential between the Fed and ECB began narrowing in 2000 but the dollar rallied another 20% until the Fed/ECB rate differential went negative. Certainly, an actual decrease in the Fed/ECB rate differential is more important than "words."

But the dollar continued to rally in 2000-2002 because the rate differential remained positive. Following the move to negative territory, currency traders said "Thank you very much, we'll do our banking elsewhere." The prime beneficiaries during the dollar collapse were high yielding currencies in 2002-2005 such as the Aussie and NZD. The reason for the dollar collapse was not the trade deficit. It was the record pace that the Fed slashed overnight deposit rates.

One of the other "non-interest rate" reasons the dollar did so well in 2000-2001 was that foreigners were buying our domestic stocks like there was no tomorrow. Note that foreign stock buying (gray line) tends to run coincident with dollar moves. While we don't use this as a primary indicator for dollar direction, we do find it interesting that in the 2000-2001 time frame the Fed/ECB bank was paying 2.5% interest and foreigners were buying stocks at the fastest rate on record. That was a pretty handsome deal for foreigners.

In our view this creates a "virtuous circle" for the dollar against the EUR and even more so against low yielding currencies like the Swiss franc. In case you haven't heard, foreigners are on track to surpass the 2000 buying frenzy. So, the well established upward trend in the dollar against the Euro and CHF should continue in 2006 until we see a reversal in this trend.

Our final chart deals with our forecast this month that the dollar would suffer a sharp correction in December followed by a "snap-back" as it would resume its rally during the seasonally bullish period from January to July 2006.

We first analyze the currency market from an interest rate perspective, then value. Finally, we take into account seasonal trends. As you can see, seasonal trends show that December is one of the worst months on record for the dollar.

Knowing this, the dollar still suffered a larger than expected decline - larger than we expected at least. But it held above the key 89 support last week (where we recommended to clients buying dollars again) and has begun to rally sharply this week.

Just so you don't accuse of of being oblivious to the overall trend, note that we think this rally in USD is simply a bear market one that is setting up a massive Head and Shoulders pattern.

In our final chart we show to you our long-term forecast for 2006-2009. Note that our forecast for a rally to 95/100 appears to be back on track. But once the dollar reaches our long held target we then foresee a sharp pullback to the 80 level from mid 2006 to the end of 2007. As such, we plan to cycle out of dollar longs next year and subscribers are already aware of what currencies we plan to sell the dollar against in 2006.