Pretty sneaky for the world to frag the dollar the other day, when U.S. markets would surely have preferred to loll about in a traditional Friday-after-Thanksgiving stupor. So what’s next for the greenback? A Christmas-Eve gang-bang, perhaps? In any event, we should always pay close attention when the dollar is getting savaged, since the sums involved are probably sufficient on a bad day to topple the global financial system from its already wobbly pins..

Was there any evidence of such jeopardy on Friday? Not that I could discern, at least not from a coldly mechanical reading of the charts. Below is a long-term picture of the Dollar Index, which settled on Friday at 83.38.  Although this slightly breached a “midpoint” Hidden Pivot at 83.52, implying at least somewhat lower prices, the worst-case scenario over the next four to six weeks would call for a drop to no lower than 79.74. Thereafter, we would probably be looking for a strong rebound.

Now, you don’t have to be a technical analyst to see that holding above 80 is absolutely crucial to perceptions of the dollar’s health. It has crossed that threshold only once, in 1992, and not by much. If the support were to be decisively breached any time soon you could kiss the U.S. economy goodbye, since it would create an impossible dilemma for the Fed. At that point, the central bank would be forced to defend the dollar with sharply higher interest rates, since foreigners might otherwise be inclined to take their surplus capital elsewhere. And what a financial catastrophe that would be! Realize that the current account deficit has been growing recently at an annualized rate of $874 billion, requiring external financing of more than $3 billion per day.

Deflation Juggernaut

But the problem with raising rates is that it could turn our already gnarly housing bust into something far worse – perhaps even a deflationary depression. In my view, serious deflation is inevitable even if interest rates do not rise in nominal terms. All it will take to set the juggernaut of deflation in motion is a ratcheting up of real rates, effectively, as the value of the collateral (i.e., homes) falls.

Although the dollar’s collapse would greatly accelerate the process, I doubt that this is about to occur, at least not yet. For one, there is the chart above: It looks bad for the dollar, but not disastrous. For two, there is still enormous demand for dollars for purposes of financial speculation. This fact is indisputable when you consider that there are $370 trillion of derivatives in play in a world the produces only about $55 trillion in real goods and services,

China & Japan

And for three, we can discount fears that China and Japan, the dollar’s main sovereign supporters, are about to diversify out of dollars in any meaningful way, as they’ve long threatened to do. The simple fact is that, to keep their export-based economies running smoothly, they will do whatever it takes to keep prevent their respective currencies from appreciating. In the case of China, the tactic is more than merely expedient, since any slowing of the country’s manufacturing economy risks idling millions of workers who have migrated from rural China to urban manufacturing centers and huge factory towns.

Meanwhile, although the dollar may look sickly at the moment, I doubt  that its collapse is imminent. If I am right, we should expect the stock market to rebound with the dollar in the days and weeks ahead. However, I am not married to this scenario, even after having predicted that the Dow Industrials eventually will rise to at least 13000. I should say that this seems no less preposterous to me now than it did when I made the prediction months ago based on purely technical factors. That is why I am monitoring stocks very closely intraday for subtle signs of an important turn, which would have to first manifest itself on the five- and fifteen-minute charts. It is also why we hold some puts with a January expiration, and why we will add to the position no matter what stocks do.