The dollar's strength could mean a thrashing for the Nifty

For more than two years the US dollar has made the Nifty dance, with the equity index moving inversely to the greenback. Now, is the dollar finally ready to trip the Nifty?

The inverse relationship between the US dollar and the Nifty is eerie. A look the comparative charts ( Click here for chart ) of the two shows the inverse relationship clearly except for a brief period in early 2011 when both moved in the same direction. To track the dollar we are looking at the UUP - the exchange traded fund that follows the US Dollar Index.

In early July 2010, the dollar began a strong selloff that lasted till November 2010. During that period the Nifty rallied from 4,785 to 6,338. After that the inverse relationship briefly went haywire with both the dollar and the Nifty falling for some time and then the Nifty rallying with the dollar continuing the fall.

In the chart, the blue vertical lines show the turning points of the Nifty and the dollar. The green arrows show prices moving up and the red ones indicate falling prices.

Since April 2011, the dollar began to rally and the Nifty fell. In the next phase, from late October 2011, the dollar again rallied and the Nifty fell. In December 2011, the dollar began falling and the Nifty rallied. By the middle of February 2012 the dollar went flat and rallied slightly and the equity index drifted lower. Since May of this year the dollar has been flat and hitting against resistance and the Nifty had rallied.

Even though there is a lag in the inverse trend of the dollar and Nifty, one can see from the chart that the inverse relationship works out eventually. Now comes the dangerous part for Nifty bulls. Notice that the dollar has reached a resistance level, as shown by the red horizontal lines. Resistance levels are areas where the supply of an asset often exceeds demand, leading to a fall in price.

The dollar has come to that resistance level multiple times and sold off. However, notice that with each subsequent rally prices have gone deeper into the resistance zone. This essentially means that the buyers are able to get more control and that prices have a higher probability of going above resistance. Usually when prices break above resistance, they tend to rally higher.

This scenario will be bad news for Nifty. Given the inverse dollar-Nifty relationship, one could see the Nifty fall on a dollar rally. This, of course, is the risk versus safe haven play. When investors become risk-averse they tend to rush to either the US dollar or the Japanese yen and junk equities. In case the dollar exchange traded fund UUP closes above 23.50 on a weekly chart, it will augur badly of Nifty.

Over the long term, the Nifty has shown relative weakness to the dollar. This essentially means that a rally in the dollar will result in a much greater fall in the Nifty, but a fall in the dollar will not lead to an equally strong rally in the Nifty.

For instance, in May 2010, the Nifty was at 4,785 and UUP was at 25.78. But in December 2011 the Nifty was at 4,531, lower than the May 2010 level, even though UUP was at 22.57 at that time. Ideally, for the Nifty to reach that low the UUP should have been at its May 2010 level of 25.78. This shows a lack of strength on the part of Nifty. Also, notice that the dollar kept falling lower, but the Nifty did not go above its 6,338 level.

So basically a rallying dollar thrashes the Nifty, but a falling greenback does not help it as much. Given these facts, Nifty bulls should hope that the dollar does not break above its resistance level.

George Albert is Editor, www.capturetrends.com