Doubling Up on the U.S. Dollar’s Rally

The popular “decoupling theory,” that the rest of the world’s economies can continue to thrive while the U.S. economy slows, has proven to be bunk. As it turns out, other global economies, not the United States, are flirting with recession. Last week, it was announced that the 13-nation, euro-area economy shrank in the second quarter, as the economies of Germany, France, and Italy all contracted. And because inflation in the eurozone is far too high for comfort, few expect the ECB to cut interest rates before 2009. That means that you can expect European economies, and the Euro, to stagnate during the foreseeable future.

And economic weakness extends far beyond the eurozone. This past week, the Bank of England’s governor, Mervyn King, (the United Kingdom’s equivalent to Ben Bernanke) predicted that Britain’s economy may enter a recession during the next 12 months. With a bigger housing bubble and even greater consumer credit expansion than the United States, the United Kingdom and its pound sterling currency have every reason to continue their downward trends.

Finally, until last week, Japan had been seen as relatively immune to the ravages of the credit crisis currently hitting the United States and Europe. But the contraction of Japan’s Gross Domestic Product (GDP) by 0.6% in the second quarter has jolted everyone out of any complacency that the world’s second-largest economy could continue to operate untouched by events elsewhere. That quarterly decline was its sharpest in seven years. 

Relentless negative headlines notwithstanding, the U.S. economy doesn’t seem to be in such bad shape after all. The U.S. economy grew at 1.9% in Q2 and a surge in export sales in June probably means that GDP growth for the most recent quarter will be revised upward. The U.S economy also has the most to gain from the recent fall in the price of oil and is likely to recover more quickly than its counterparts in Europe and Asia. That also means U.S. interest rates will head higher, sooner, to provide a further boost for the dollar. And the dollar’s revival is likely to put to rest talk of global central banks and other large holders of reserve assets diversifying out of the U.S. dollar.

So how far would a dollar rally go? On measures such as purchasing-power parity, the U.S. dollar still looks cheap against the euro, the Swedish crown, the Swiss frank and the U.K. pound sterling. A further 20% rally from current levels seems not a question of “if”, but “when.”

The best way to play the dollar rally is to buy the Direxion Funds Dollar Bull 2.5x Fund (DXDBX) — a leveraged fund that seeks daily returns of 250% of the price performance of the U.S. dollar against six major world currencies: the euro, yen, pound, Canadian dollar, Swedish krona and Swiss franc. That means a 20% gain in the dollar should translate to a 50% gain in the fund. Place your stop at $28.25. With this kind of leverage, the fund should trade like a fairly volatile stock.

For even bigger potential profits, buy the December $22.50 options (UUPLX.X) on the PowerShares DB US Dollar Index Bullish ETF (UUP). Although I’m not recommending this ETF itself, as it does not offer leverage, the options on UUP offer even greater potential profits.

PORTFOLIO UPDATE

Last week’s bet on the dollar’s rise against the euro got off to a solid start with the Market Vectors Double Short Euro ETN (DRR) up 4.58%, as of Friday’s close.

We stopped out of SPDR Gold Shares (GLD) and the remaining options in that position last week for a loss. As usual, we sell the options whenever we stop out of the accompanying stock.

Although you haven’t hit your stop yet, sell your iPath DJ AIG Aluminum TR Sub-Idx ETN (JJU) here at a loss. As with a strong dollar scenario, I don’t see commodity prices recovering strongly in the near future. Better to put your money to work elsewhere.