Follow the Dollar Index

 | Dec 29, 2011 | 2:00 PM EST
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The U.S. Dollar Index is a basket of six major currencies weighted against the greenback and rolled into one composite price index. It's not only a barometer of the health of the U.S. currency but also of the general health of the U.S. economy. The value of the U.S. dollar on the foreign exchange markets also exerts influence over many other markets, especially on a day-to-day trading basis.

Traders and investors should keep a close eye on the U.S. dollar index in the new year, as it will continue to provide guidance and influence over many other markets, including the U.S. stock indices, U.S. Treasuries and raw commodity markets.

The dollar index had a very good year in 2011 and hit a fresh 11-month high just last week. The index has been trending higher from the May low (which was a nearly three-year low). The present technical posture of the dollar index remains fully bullish heading into 2012.

Before forecasting the dollar's impact on markets in the new year, it's prudent to review its effects on key markets in 2011 -- because there will be a twist in 2012.

During the first half of this year, the dollar index was in a solid price downtrend. The weaker U.S. currency was bullish for most commodity markets, with many of those markets hitting new all-time or multi-year highs in the first half of the year. Most commodity markets are priced in U.S. dollars. When the dollar is weaker, these commodities are cheaper to purchase using other world currencies.

The first half of 2011 saw the major U.S. stock indices trend sideways to higher, with the major indices hitting multi-year highs in May. Stock traders and investors viewed the weaker greenback as bullish for stocks because it suggested that the Federal Reserve's easy money policy, which is fundamentally U.S. dollar-bearish (lower U.S. interest rates) meant stocks would be the best performers, among other investment assets, in coming months. When the dollar index bottomed in May, the U.S. stock indices hit their peaks for the year.

The U.S. stock indices and most commodity markets had dismal third quarters as the dollar index staged a solid price recovery during the same time span. In the fourth quarter of 2011, however, the worm started to turn for the relationship between the U.S. dollar index and the stock indices, as both were able to sustain rallies into the end of the year.

Meanwhile, most commodity markets, while not establishing any major fresh price uptrends, did mostly stabilize from their downtrends. Crude oil's price strength in the fourth quarter helped to limit selling pressure in other commodity markets.

With the new year, look for the relationship between the U.S. dollar index and the stock and commodity markets to continue the phenomenon that appeared in the fourth quarter of 2011: A stronger dollar can co-exist with rising stock and commodity prices. In fact, it's likely that the U.S. dollar index will continue to post gains well into the second quarter of 2012, and maybe for the entire year.

It's also likely that the U.S. stock indices will continue to trend sideways to higher and set new multi-year highs during the first half of 2012. It's also likely that most major commodity markets will fare well in the new year.

The major reason for the dollar index, stocks and commodities likely being able to sustain price uptrends for 2012  is stronger worldwide economic growth. The U.S. is already experiencing generally better economic data in late 2011. Despite sovereign debt problems for the European Union that could continue to limit European economic growth in 2012, Asian economies are still strong. China's growth rate could back off a bit in 2012, but that commodity-consuming behemoth's GDP is still projected above 8% annually. Stronger worldwide economic growth means better demand for raw commodities, and an improving picture for stock markets.

The EU's debt crisis will linger into 2012, which will also be U.S. dollar and U.S. stock market bullish, as investment monies from Asia and Europe continue to flow to U.S. shores -- either into U.S. stocks or U.S. Treasuries.

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