The dollar finally reached our 79.60 target [see: Sep 20 Update] overnight and should see a bit of a technical bounce here at a large scale .886 (white) and medium scale 1.618 (purple.)

But, as we’ve discussed the past few days, there is plenty more downside after the bounce.  For starters, an alternate .886 at 79.436 based on 78.725 as Point X is a possibility (light blue.)

Based on fact that SPX just broke out of a rising wedge, I’d say it’s a very good possibility (watch for a potential channel top at 1741.)

And, then there’s the rising red channel (dating back to May 2011), which broke down on Sep 18. It’s seen its share of equity highs and lows (SPX values in yellow below.)

But, it’s managed to stay on an upswing ever since — until the Fed announced no tapering last month. Now, with no tapering and no budgetary discipline, the market is correctly wondering what — if anything — might provide a floor.

While a declining dollar can be positive for US exporters, we’re a net importer.  Anyone who buys food, clothing, electronics, gas, automobiles feels the pinch right away.  But, it also shows up in raw materials, affecting almost all capital and consumer goods one way or another.

The chart below shows how a declining dollar typically leads to an increase in CPI.  When the dollar broke down in 2002 (the red trend line), it touched off a six year increase in CPI.

Inflation plunged in 2006 when it appeared the dollar had found its bottom (the yellow channel.)  But, when that channel broke down, CPI soared from 1.3% to 5.6% until 2008, when DX finally did bottom.

Inflation plunged in 2008 as the global economic meltdown took hold and buyers disappeared from the scene, eventually sinking into negative growth (deflation) for much of 2009.

Central bankers came to the rescue.  The first round of quantitative easing in 2009 did, in fact, bring inflation back from the dead.  CPI spiked from -2.1% in Aug 2009 to +2.7% in December 2009.  Gold soared 33% from 900 to 1200 in the same period (already up from 681 in Oct 08.)  The S&P 500, which had bottomed in Mar 09 at 666, managed its own 33% rise from 869-1150.

By early 2010, the dollar was on the rise again – accompanied by a slump in annual inflation to only 1%.   When the dollar peaked in June 2010, inflation leveled off.  It spiked in November, however, when QE2 was announced.  The dollar held on valiantly, but the purple channel broke down in Mar 2011 and CPI ran up to nearly 4% again.

This time, it was a market crash that saved the dollar.  The dollar bottomed as SPX topped in May 2011, and gained dramatically between August and October as the market melted down.

It was enough to kick start another dollar rally that lasted until QE3 in Sep 2012 — which might have remained the peak had it not been for two factors that sent the index skitting higher:

• Abenomics — the Japanese, outdoing the Fed at QE
• the market scare in June 2013

Since then, it’s been all downhill for the dollar.  As mentioned back in January, if 78.725 doesn’t hold, look out below.  The next downside support isn’t until 77.48 and then 75.45.  If our equity forecast is accurate, we’ll find out very soon.