The U.S. dollar has been selling off on speculation that a government sponsored plan to buy illiquid mortgage assets from financial institutions will aggravate the budget deficit and make the U.S. tax payer more vulnerable to a slowdown in the U.S. economy. However, it seems we are seeing an overshoot of market sentiment against the U.S. dollar since it’s too early for market players to make conclusions regarding the true cost of this rescue plan. In fact, the U.S. government is going to hold both assets and liabilities and it’s even possible for them to make a substantial profit. It is difficult to make forecasts, particularly when the currency market is very volatile. Nonetheless, we expect the U.S. dollar to rebound sharply against the euro.

The U.S. dollar has been very weak against the world’s most heavily traded currencies. For instance, this Monday the U.S. dollar lost more than 300 pips against the euro on speculation that a government sponsored plan to buy illiquid mortgage assets from financial institutions will aggravate the budget deficit and make the U.S. tax payer more vulnerable to a slowdown in the U.S. economy. However, it seems we are seeing an overshoot of market sentiment against the U.S. dollar since it’s too early for market players to make conclusions regarding the true cost of this rescue plan. In fact, the U.S. government is going to own both assets and liabilities and it’s even possible for the U.S. government to make a substantial profit if the housing market stabilizes in 2009. It is always difficult to make forecasts, particularly when currency market is very volatile. Nonetheless, we think that once investor’s confidence in the U.S. economy gets restored the U.S. dollar is likely to rebound. Indeed, a severe undervaluation of the U.S. dollar is now likely to lead to a substantial improvement of the U.S. Balance of Payments through continued strong export performance. In addition, a significant shift of interest rate expectations in favor of rate hikes by the Federal Reserve and rate cuts by the ECB is likely to help the U.S. dollar to rebound sharply against the euro.

Keeping a longer-term perspective, especially when markets are as turbulent as they have been lately, helps to combat the emotional impulses that hinder most in their speculative activities. Since the 1970s (DM rates before 1999), the EUR/USD has nearly tripled, but there have been large swings in both directions. A cycle is evident whereas the EUR/USD falls for roughly half the time of the preceding advance. If this cycle holds, then a 4 or 5 year USD advance may be underway. Of course, no cycle holds forever. To get a better idea of future prospects, we’ll need to examine the structure of the advance from the 2000 low.

The advance from the 2000 low counts well as a 5 wave impulsive. Following 5 waves, markets correct in the other direction in 3 waves. Weakness from 1.6040 is most likely the beginning of a 3 wave correction. An impulse usually experiences at least a 38.2% retracement. In this case, 1.2428 is the 38.2% level. The 50% at 1.1486 is defended by the 4th wave of one less degree (2005 low). Another sign that a larger EUR/USD correction is underway is the position of weekly RSI, which recently dipped below 30. A dip below 30 indicates a rate of change extreme to the downside. Rate of change extremes typically occur in the beginning and middle of moves, not the end. This is why rate of change extremes rarely occur at the same time as price extremes and why divergence between price and rate of change / momentum oscillators warn of turns in price. For example, the highest RSI reading (14 weeks) during the entire 2000-2008 bull trend occurred in June 2002 and the lowest RSI reading during the decline from 1.3666-1.1640 occurred in May 2005 (the EUR/USD did not bottom until November 2005).

Zooming in close and taking a look at the daily, it is clear that the decline from 1.6040 is in 5 waves, indicating that there is additional downside potential (there is a count that allows for the resumption of strength from here but we favor a larger decline…for reasons previously mentioned). Expect resistance in the 1.4919-1.52 zone. This is the 50%-61.8% of 1.6040-1.3877 as well as the former 4th wave.

Antonio Sousa is a Currency Analyst for FXCM.