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. However, expectations about the U.S. economy are not the only factor affecting dollar valuation. Increasing attention to public sector deficits are becoming more noticeable. What traders need to understand is that emotions and expectations regarding government debt can become as important in impacting the value of the dollar as economic data. The emergence of a major event risk, the U.S. mid-term elections in November 2010, is now on the horizon for the dollar.
Elections always have had an impact on currencies. Elections affect currency values because they introduce uncertainty regarding the outcome, and therefore more volatility. The British election on May 6 is a case in point. It resulted in a shift in control of government to the Conservatives, in a coalition with the Liberals. The pound sterling dropped precipitously immediately after the election and then rebounded 17 points. The fiscal austerity budget and policy of new British Prime Minister David Cameron introduced in the June 22 budget to Parliament was followed by a strengthening of the pound. This is not a coincidence. In effect, the currency market also voted its approval of a departure from the era of stimulus spending to one of fiscal prudence. This sentiment shift is now global in nature, and has pitted traditional Keynesians that champion public sector spending to trigger growth against public sector deficit hawks that urge the contraction of the public sector. European 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. As a result, the U.S. mid-term elections may have a major impact on the U.S. dollar.
If the elections result in a shift in control of the House of Representatives, a policy shift likely will occur away from fiscal stimulus and increase prospects of 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 shift in control of the Congress will represent unique trading opportunities in the currency market.
There are several trading scenarios that come into play. Although there are many different ways to play a U.S. dollar move, a basic approach is to trade the U.S. dollar index. There are two ETFs that will allow anyone with an equity account to participate. Those who think the election will be dollar positive can play the PowerShares DB U.S. Dollar Index Bullish Fund (UUP) listed on the NYSE. This ETF goes long the USDX futures contract. In contrast, the PowerShares DB U.S. Dollar Index Bearish Fund (UDN) shorts futures contracts. So far this year UUP is down 6.52% while UDN is up 5.19% (see "Mirror image").
Options are available in both the UUP and the UDN ETFs allowing volatility as well as directional trades. A Dec. 10 option expiration date would enable participating in the sentiment build up to the election as well as the election results. If election polls indicate a potential for a major change in power, the resulting increase in volatility will increase the value of the calls. If polls point to a retention of power by the Democrats, puts on the UUP or calls on the UDN would be an appropriate trading strategy. Traders wanting maximum participation in any movement should look to an at-the-money strike price ($24 as of Aug. 2 for UUP and $26 as of Aug. 2 for UDN).
An at-the-money straddle, which would be buying a call and put at the same strike in either the UUP or UDN, would appeal to those who don’t want to predict the outcome, but believe that the impact of the result would be a large move in either direction.
While neither political party necessarily follows through on its rhetoric and, given recent history, it would be grossly inaccurate to imply Republicans are more fiscally responsible, it is also true that fiscal prudence has come with split government and larger deficits have occurred when one political party controlled both the Presidency and the legislature. Therefore, a Republican victory in November should slow spending. In any case, the U.S. mid-term elections may become one of the main events of the currency markets.
Abe Cofnas is the author of "Sentiment Indicators" (Bloomberg Press). He can be reached at firstname.lastname@example.org.
More from Abe Cofnas:
Three Ways to Trade the Yuan
5 Tips for Chaotic Forex Markets