As the market breaks to new highs and fundamental valuations reach record levels, taking bullish positions in stocks may feel a little risky. If you’re like me, you usually try to wait for pullbacks to get the best entries.
But the U.S. dollar (USD) is another story.
Instead, the greenback derives value from the strength of our nation’s economy — specifically, the perception of our economy’s growth, stability and monetary policy (e.g., interest rates).
That means headlines and economic data are often big drivers of the value of the dollar relative to other currencies.
How Economic Factors Drive Currencies
Economies and currencies have a complicated relationship. The strength of any one currency cannot be measured in a vacuum; its power is always relative to another currency. When discussing currency strength, the question isn’t: Is the U.S. dollar strong? Instead, we’re really asking questions like: Does a U.S. dollar buy more or fewer euros than it previously did?
To measure the strength or value of a currency, you must pair it against another currency. (This is why currencies that trade in the Forex market always trade in “pairs.”)
An example would be to state that 1 euro (EUR) is currently worth 1.06 U.S. dollars (USD). If 1 EUR could previously buy 1.25 USD, we could then say that the EUR is relatively weak, and the USD is relatively strong.
But how is that relative strength or weakness decided? It generally comes back to the countries’ economies. If one country is experiencing strong economic growth, its currency will gain value relative to countries with slower growth.
Interest rates play a role in all of this by signaling the strength of an economy. When the economy struggles, central banks may lower interest rates in an attempt to boost the economy by making it cheaper to borrow money. But as employment, GDP and other factors improve, rates should increase.
Most traders and analysts therefore draw a line between interest rates and currency. If a strong economy means stronger currency, and if higher interest rates indicate a strong economy, then higher interest rates should correlate with stronger currency.
But, again, the true power isn’t in any one currency — it’s the relationship between two different currencies and economies. And right now, I’m seeing signs that suggest the U.S. dollar is going to gain a lot of strength against the euro.
I believe that headlines surrounding Trump’s presidency and the economic data on tap for the next quarter are going to be very supportive of a strengthening U.S. dollar. At the same time, widespread economic uncertainty throughout Europe could weaken the euro. And there is a simple way investors can profit from these trends that doesn’t involve trading any currencies.
Things Are Good Here in the US… Not So Much in Europe
Love him or hate him, Trump is pro-American business, and he’s been very vocal about improving domestic commerce.
Trump’s victory sent domestic small-cap stocks soaring, with the Russell 2000 jumping 12.7% in the two and a half weeks that followed. This shows that investors believe Trump’s policies will work wonders on domestic commerce. And as I mentioned earlier, that kind of healthy economic growth is very positive for the dollar.
Another important issue on Trump’s agenda is the Federal Reserve and how it’s handling interest rates. Trump has aggressively criticized Fed Chair Janet Yellen’s “easy money” policies, and while he can’t remove her from the position before her term ends in January 2018, it doesn’t mean he can’t make changes that could shake things up.
Currently, there are two vacancies on the FOMC’s board. Even though the Fed is supposed to act independently of political pressures, Trump has the power to appoint Fed members with more hawkish views (e.g., higher interest rates) — something many in the Republican Party are in favor of. While an increase in interest rates would make it more expensive for companies and individuals to take out loans, it would signal a U.S. economy that is healthy and growing.
On top of everything else, unemployment is low and GDP growth is being revised higher for the fourth quarter and beyond.
The USD certainly has a tailwind going into 2017, while a number of forces will be working against the euro.
While the U.S. dollar is growing stronger, potential upheaval in Europe could further hinder the unity of the continent and the strength of its currency.
On Dec. 4, Italy voted down a constitutional referendum that would have decreased the power of Italy’s senate and transferred regional power to the country’s central government. This could trigger several bank failures — a potential economic catastrophe. Italian Prime Minister Matteo Renzi also resigned after the vote, and The Wall Street Journal sees similar potential upheavals occurring across Europe in the coming year.
While the U.S. economy has grown, the eurozone is teetering on a potential re-entry into recession and has a 10.1% unemployment rate, roughly double that of the United States.
Earlier this year, Credit Suisse warned that the current weak economic trajectory could trigger a full-blown euro collapse. While this is certainly a worst-case scenario, the feasible reality of a breakup has the European Central Bank (ECB) working hard to prevent it through low rates and continued stimulus — monetary policies that both result in a weaker currency.
The best way to take advantage of these forces is with the CurrencyShares Euro Trust (NYSE: FXE), which tracks the value of the euro against the U.S. dollar. This ETF allows us to trade the EUR/USD relationship just like we would trade a stock. Basically, when the value of the euro (relative to the dollar) decreases, so does FXE’s price.
Because we are betting on a decline in the euro, we want to take a short position in FXE. If we short 100 shares of FXE, it would cost just over $5,200 on a 50% margin.
– Jared Levy
Sponsored Link: But I also recently recommended a trade that would risk just $340 and could turn a roughly $2 drop in FXE into 17.6% profits by Inauguration Day. You could easily take advantage of a trade like this as well, but you’ll need to see this first.
Source: Profitable Trading