US dollar has been a good indicator of risk-off/risk-on trade for quite some time. Whenever investors become unsure of the economic conditions and when the fear level increases they flock towards US treasuries and US dollar. In the currency domain, Swiss Franc and Japanese Yen trump dollar’s safe haven status and they normally go up agianst the dollar in times of uncertainty when all other currencies fall. This phenomenon was in display when S&P downgraded the AAA rating of the United States.

Many commentators are also clamouring for the rise of dollar – especially in light of the troubles in the Euro zone. But take a look at this weekly US Dollar index chart:

Dollar Index has been in a downtrend since June 2010 with a short rally in Aug ’10, Nov ’10 and Apr ’11. However, since Apr ’11 it has been making an upward sloping flag — a bearish formation — though this flag is not as steep as the previous ones.

Does this look like that the index is set to rally or is it nearing another break down?

There are couple of other points to consider too. Dollar Index is testing the breach of double top neck line formed by the high on Mar ’09 of 89.11 and the high on Jun ’10 of 88.71. In between the index reached a low of 74.17 in Nov ’09. Recently the index fell below this low in Apr ’11 but since then it is going up and down of this level for the past 4 months. In case the break below the low Nov ’09 holds and the double top formation completes then the potential target would be 59.23, which would be a massive dollar sell off lasting many months.

EUR constitutes the biggest share of the Dollar Index — 58.6%. The weekly EUR/USD chart is showing a downward sloping flag, a bullish formation. This says that likelihood of an upward breakout of EUR/USD is significant, which supports the possibility of Dollar Index breakdown.

Just in case you think that the technical analysis makes things very simple, there is another curve to this analysis. EUR/USD has been in a downtrend Jul ’08 and is making lower lows. However, it is in an uptrend since Jun 2010 making higher high. If the downward sloping flag breaks upward and the pair clears May ’11 high of 1.4940 and the Nov ’09 high of 1.5145 then the next resistance would be Jul ’08 high of 1.6038.

On the other hand, if the pair breaks below the Jul ’11 low of 1.3837 and the downward sloping flag then the next minor support would be 1.2860, the low of Jan ’11 and the major support would be 1.1877, the low of Jun ’10. This would be bullish for the Dollar Index based upon the pair’s weighting in it.

That is why I like technical analysis. Chart formations give you alternative scenarios with different probabilities. After that you need to evaluate those scenarios within the market context and select the one that you think has a higher probability of occurring. The technical analysis also tells you when your conclusions will turn out to be correct or wrong. Then you can determine the potential risk and reward of your conclusions.