While many people are on summer vacation, and perhaps paying less attention to the markets, the underlying reality is that the markets are sentiment machines. They are always looking for new information to formulate risk aversion or risk appetite. Certainly, markets don’t take the summer off.

In fact, recent economic uncertainty regarding a U.S. recovery is causing an increase in bearish sentiment on the U.S. dollar. The U.S. dollar index is approaching a key support level of 80, as you can see in the USDX chart below:

Below 80, we enter virtually new territory from a technical and psychological level. However, option strategies should always consider alternative scenarios. Just as the crowd is bearish on the dollar, it’s useful to see what scenarios could point to a bullish dollar countermove.

Part of a contrarian view on the U.S. dollar is understanding that dollar valuations are based on more than just economic news. Even if the economy is weak, the U.S. dollar can still go up. We saw this in September 2008, when the market breakdown was followed by a surge in the U.S. dollar.

Today there is increasing attention on government deficits. And those emotions and can become as important as economic data in impacting the value of the U.S. dollar. It’s all leading to a major “event-risk” that is now on the horizon – the U.S. mid-term elections in November 2010. Elections always have an impact on currencies. They affect currency values because they introduce uncertainty regarding the outcome, and therefore more volatility.

It is not too early to start thinking about the upcoming U.S. elections and how they can affect the U.S. dollar.

To see why, let’s look at some recent history — more specifically, the British elections of May 6.

The election resulted in a shift in control of government to the Conservatives, in a coalition with the Liberals.

On May 6, the pound sterling was at 1.4470. Since then, it has proceeded to climb in a clear upward channel to 1.5835. The fiscal austerity budget and policy that new U.K. Prime Minister David Cameron introduced to Parliament on June 22 provided even more momentum in the pound sterling.

This is not a coincidence. In effect, the currency market also voted its approval of Britain’s departure from the era of stimulus spending to an era of fiscal prudence. This sentiment shift is now global in nature, and has pitted traditional Keynesians who champion public sector spending to trigger growth against public sector deficit hawks who urge the contraction of the public sector.

EU central bank president Jean-Claude Trichet is an example of the anti-Keynesians, while Nobel Prize-winning economist Paul Krugman and Financial Times economist Martin Wolf have championed further spending. There should be no doubt that this debate will dominate the attention of the markets in the coming months.

So, then, how will the U.S. midterm elections impact the U.S. dollar?

If the elections result in a shift in control of the House of Representatives, from the Democrat party to the Republicans, a policy shift will surely occur – taking away fiscal stimulus and increasing prospects of a deficit spending reductions. If the Senate also falls to Republican control, the magnitude of a sentiment wave expecting fiscal “austerity” is even more probable. Such a total shift in control of the Congress will represent a political earthquake. It will also represent unique trading opportunities in the currency market.

In the near future I will be articulating several trading scenarios that relate to the U.S. elections and the U.S. dollar.

It could be an unprecedented opportunity for option trading. Stay tuned!

Best,
Abe Cofnas
Penny Sleuth

August 12, 2010

Abe Cofnas

Abe Cofnas has been a full-time analyst of global currency trading for over twenty years and ranks among the top Foreign Exchange (Forex) traders working today. He has written three books on the subject. The most recent, Sentiment Indicators was published in 2010. Cofnas is the managing editor of the Fear & Greed Trader, Agora’s primary source for currencies information. He has also been Futures Magazine’s Forex Trader columnist since 2001, having written over 100 pieces.

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