In the last update we made about the dollar on June 10 we said that our expected strong rally from January to June would be followed by a renewed slide from September to December. Below is the same chart from our May 8 report, which we updated on June 10 to publicly say, "We will soon look to close out our dollar longs" from earlier this year.

We forecasted a top at 91 and the actual price high was 90.77. So with our dollar forecast right on track, we have warned for the past month of the upcoming “September Slide” which would see the dollar decline from September to October.

The reasons are quite simple - The fundamental driver of currency rates (as we explained many times) is interest rates.

Longtime readers should remember that our forecast was for a rising US dollar from January to August 2005 then a decline from September to December. We said a top in the dollar would coincide with a peak in the Fed’s rate hiking cycle at 3.5%.

While the rest of the market was calling for 4.0% a month ago, we note that the recent decline in the 5-year and 10-year notes to 3.77% and 3.98% makes another Fed hike too close for comfort. The Fed now risks inverting the yield curve with another rate hike. This situation is causing traders to unwind long dollar positions in droves.

Below we show the yield ratio between the 5-year note and the 3-month Treasury bill. Recall that the last two times this ratio threatened to invert the Swiss franc/US dollar rate saw a sharp spike (orange). This is simply Economics 101 at work.

The difference this time though is that the US dollar will likely undergo a 3-4 month correction of its recent gains but will rally again in 2006 because of the large interest rate differential in its favor. Recall that we predicted a dollar rally from January to August to then reverse course in September as the market realized the Fed would pause in its interest rate cycle at 3.5%. This in turn would cause an unwinding of long dollar positions, which would set up the next significant rally for January to August of 2006.