Potential Trouble Brewing: Dollar Breaks Out While Gold and Yen Hold Steady

The U.S. dollar index is only trading back to levels from last summer. However, from a technical standpoint, the dollar has broken out: the short-term downtrend has ended, and the current move has considerable upside potential.

*Chart created using TeleChart:

The chart above shows that the dollar’s break below the 200DMA in May led to a prolonged decline. At the time, I used this break to insist that the dollar had topped out and was heading much lower. Last week I speculated that this downtrend was potentially ending based on the dollar’s interaction with the 200DMA over the last four years.

For now, I see considerable upside potential for the dollar from here. More importantly, both gold and the yen held steady in the face of the dollar’s impressive move this week. Gold still clings to important near-term support, and the U.S. dollar continues its trend of weakness against the Japanese yen (starting from April, 2008).

(*Charts created using dailyfx.com Powercharts)

If these trends and support hold up, I cannot help but believe that the market is bracing itself for the impact of brewing trouble. For example, a stronger dollar and yen hurt the carry trade which relies on a weak, low-interest currency (other “zero-cost” currencies like the Swiss franc and the Canadian dollar probably cannot provide enough liquidity to handle a complete transfer in carry trades). As carry trades are closed out to lock in profits or limit losses, risky assets like stocks and certain commodities will continue experiencing selling pressure – at least to the extent that carry trades were responsible for floating assets around the world.

If gold holds steady with the dollar, it is gaining ground against declining currencies in the dollar index like the British pound and especially the euro. Such a move could signal more devastating news about Europe’s sovereign debt problems.

Of course, I am speculating here. After all, the Australian dollar and the Canadian dollar looked resilient against the dollar’s advance until this past week, serving reminder that trends and support are always subject to change at any time. Just last month, it seemed that the stock market had finally decoupled from the U.S. dollar. Nonetheless, I think the above possible interpretations of current developments in currencies have a high enough likelihood to warrant close attention and aligning trades accordingly.

Be careful out there!

Full disclosure: short EUR/USD, long USD/JPY, long AUD/USD, long FXA, short GBP/JPY, long USD/CAD, long GLD