Seven Stages of the Dollar

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“How poor are they that have not patience! What wound did ever heal but by degrees?”

                           William Shakespeare

FX Trading – Seven Stages of the Dollar

It’s always difficult to pinpoint where we are in terms of a trend. Long-term trends in the currency markets have ranged from six to ten years, measured by the various bull and bear markets in the dollar since the inception of the free-floating currency market back in 1971. Here’s the pattern of long-term bear and bull markets in the dollar as measured by the US $ Index:

1971-1978: Seven-year bear market (President Nixon closes the gold window closed)
1978-1985: Six-year bull market (Fed Chairman Volcker squeezes inflation)
1985-1992: Seven-year bear market (Triggered by the Plaza Accord)
1992-2001: Ten-year bull market (Tech boom and money flow to US assets)
2001-2008: Seven year bear market (bottom on the credit crunch)
2008- ? : Next major bull market?

No one can say when multi-year bull and bear markets end without some perspective. But we can evaluate conditions as they develop that may indicate the potential for a change in the big trend. I use the boom/bust cycle of price action to help put this longer-term moves into some type of perspective.

The dollar, especially from a longer term perspective, moves in waves—discernable waves based on human emotion and supported to differing degrees by the underlying economic fundamentals at various stages along the way. It sounds complicated but it’s not. Here’s an example of the waves or stages of the dollar in a boom/bust price cycle…

  • Stage 1: The unrecognized trend – This is the early on stuff. It represents the beginning of a new trend that is recognized by only a few of the major players.
  • Stage 2: The beginning of a self-reinforcing process – This is the stage where the consensus begins to realize there are real underlying fundamental reasons why this ―new‖ trend has legs. This is the most powerful and longest leg or wave of the trend.
  • Stage 3: The successful test – This is the pull-back that challenges the consensus view, it represents a significant retrace of the prior wave ―self-reinforcing‖ wave. In the case of the dollar, the bear market correction we witnessed during 2005 is an example of a ―successful test.‖
  • Stage 4: The growing conviction, resulting in a widening divergence between reality and expectations – This represents the last major leg or wave of the trend. It is supported by real fundamentals or expectations of how the fundamentals will play out, but it also represents the stage in which the currency is either ―overvalued‖ or ―undervalued‖ on a pure fundamental basis.
  • The best recent example was the leg-up in the British pound during the credit-induced bull phase. It was supported on strong growth in the UK economy and an aggressive Bank of England. But on a purchasing power parity basis (a key long-term indicator of real value) the pound was extremely ―overvalued,‖ relative to the US dollar. But that didn’t mean the move was over. We still have the climax stage before the bull phase ends.

  • Stage 5: The flaw in perceptions – This is the stage in the cycle when some of the major players begin to realize the currency cannot be supported by the fundamentals, as highlighted above.
  • Stage 6: The climax – This is the final stage of the move, and represents the ―overshoot‖ we often see in currency markets because they tend to be more sentiment driven and price-led than other asset markets.
  • Stage 7: A self-reinforcing process in the opposite direction – The trend begins in the opposite direction.

….Keep in mind the ―climax‖ stage is far away in this new dollar move; when reached you will know it. That’s when everyone in the world will love the dollar everyday all the time. Shoeshine boys will be playing the FX market, go long the dollar and making a killing. That’s when you know we are very close to Stage 7, time to start looking in the other direction.