If the August surge in the US dollar caught many traders off guard, it was not because of a lack of focus on the US economy. If anything, the reason the surge surprised so many was possibly because of too much focus on the US economy. The continuing downward spiral of  “Fannie and Freddie,” an anemic housing market that seems to never get any better, and a credit crisis that has many comparing it to the S&L debacle of the early '80s was enough to keep most US investors occupied. Combine all of that with $4.00 a gallon gasoline punching at the US consumer and it is no wonder that most would’ve bet against the US currency strengthening any time soon.

As is usually the case, however, the heard was wrong. The dollar surged sharply in early August sending many shorts to cover quickly – which accelerated the rally. The newly invigorated dollar however, was not ignited by a miracle turnaround in the US economy or even a hopeful solution to the ongoing credit crisis. The dollar’s strength was merely a reflection of the rest of the world economies flashing indicators that they were beginning to follow the US into the malaise that began to creep through the US economy and financial markets over a year ago.

Those who thought that the economic slowdown would be a US event from which the rest of the world would be immune are starting to look wrong.

To use the metaphor of a roller coaster, think of national economies as all of the cars in the coaster train. The US was the first car in the train and some 12 months ago, went over the crest of the hill and began barreling towards the bottom of the track. But while the US was moving downwards on the coaster track, Europe was several cars back, still at the top of the crest. It was at this point that the disparity between currencies grew the most as the US currency plunged while European currencies gained. Many, unaware of the “coaster effect,” felt that Europe would be largely insulated from US economic woes.

This month, it appears that Europe’s coaster car came flying over the crest and began it’s decent towards the bottom of the track. Calls of “we’re not alone!” could be heard from the US’s lead coaster car.

The US dollar then, surged not because of any US strengthening, but because of European (and other nations) economies weakening. People stopped selling dollars and started selling Euros. The Euro was not that much more valuable than the dollar and a correction was in order.

The adjustment was fast and furious but it was necessary to bring currencies back into equilibrium. The question is, what now?  Does one short the dollar in expectation that the currency will decline once again as the economy takes another surge downward? Or, does one bet on a continuation of the trend on the premise that the dollar still has some ground to regain on the Euro?

Our longer-term bias here at Liberty Trading is towards the latter.

We’re not suggesting an abrupt recovery in the US economy. However, our opinion is that the US is further along in the economic cycle than the Europeans. And that should add support to the dollar and pressure the euro in the coming months.

The latest economic data continues to support this “roller coaster” theory.

For much of 2008, the dollar has continued to get battered as a potent combination of growing national debt, the housing/credit crisis, and a slowing economy have kept the Fed from fiddling with already low interest rates. At the same time, European central bankers remained convinced that inflation was the biggest threat to European economies and thus many felt rate increases were in the cards. This made the Euro an even stronger currency.

But cracks soon began to appear in the inflation argument and evidence began to mount that European economies were slowing and inflation was easing. As we enter the final month of the third quarter, the data is starting to look overwhelming. This week, data from the German Federal Statistics office suggested that German annual inflation slowed to 3.3% in August from 3.5% in July. Germany is Europe’s largest economy and accounts for nearly one third of the euro-zones overall inflation measure. Data on Friday is expected to show that inflation in the overall European Union fell in August as well. Inflation slowing means that the possibility of rate hikes decreases. This has hurt the Euro and should continue to pressure it as inflation continues to fall.

In Spain, the bloc’s fourth largest economy, the country’s National Statistics Institute showed second quarter GDP slowed to an annual rate of 1.8%, from 2.6% in the first quarter.

More convincing of a European economic slowdown, however, was Thursday’s report showing Europe’s M-1 money supply’s expansion rate fell to a record low 0.5% rate from the same month a year ago, down from an annual growth rate of 1.4% in June. M-1 money supply measures currency in circulation and overnight deposits. A rapidly falling M-1 is often an indicator of recession.

At the same time, the US commerce department this week said that US GDP rose at a seasonally adjusted 3.3% annual rate in the April-June time period. This is well above the previous estimate of 1.9% and economist’s estimate of a 2.7% rise. US weekly jobless claims showed workers filing first time claims for unemployment benefits fell last week.

If the US is indeed first in / first out, it would bode well for the dollar.

Option players could look to sell calls in certain commodities as a stronger dollar could serve to pressure some markets to a certain extent. However, the fundamentals of the particular commodity could also play a role and would have to be considered.

For the pure play on a slowing European economy, we favor selling calls on the Euro futures contract. The currency has taken a dive as of late as the dollar has rallied. Near term technicians may take issue with getting short here. However, a look at weekly charts show that the Euro still has quite a way to fall if it decides to move in that direction. With the trend as our friend and economic data supporting the trade, we like selling calls in the December contract at strikes back near the July highs (see chart) for premiums in the $500-$550 range.

Figure 1: Euro Call Dec 08

Remember that when selling calls, the market does not necessarily have to move lower to profit. It only has to stay below ones strike to expire worthless, leaving the seller to keep the collected premium as profit.

We would look at limited rallies over the next 7-10 days as opportunities for entries.

Note: The opinions presented here are that of Liberty Trading and not necessarily shared by Optionetics and/or its instructors.

James Cordier & Michael Gross
Contributing Writers, Liberty Trading Group
Optionetics.com ~ Your Options Education Site
Questions for James and Michael? Visit the Optionetics.com Discussion Board