Here's How to Profit When U.S. Dollar Flies on Accelerated Inflation

NEW YORK (TheStreet) -- A divergent economic trend between Europe and the Unites States could set the stage for a prolonged rally in the U.S. dollar, while the euro weakens.

PowerShares DB US Dollar Index Bullish (UUP), a fund designed to track the value of the U.S. dollar, could continue to move upward as the weak European economy and the rising inflation in the United States lead funds into the dollar.

As the economic activity falters and inflation remains subdued, the European Central Bank is expected to continue enacting a loose policy over the next year.

Earlier this month, Germany surprised forecasters when it posted sharply lower industrial production for May, falling 1.8% month on month on a seasonally-adjusted basis, well below the consensus for a flat reading and April's downward-revised decline of 0.3% (from 0.2%).

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As shown in the chart below, German industrial production has declined steeply since the beginning of 2014.

German economic data courtesy of TradingEconomics.com

The decline in the annualized output comes alongside a core inflation rate in the euro area that remains stuck between 0.7% and 1.0% annual growth, well below the ECB's 2% target.

The German economy is Europe's largest and accounts for nearly a third of euro zone gross domestic product. If Germany begins to slow, the currency bloc's tepid 0.8% annualized economic growth of the first quarter could evaporate to nothing.

ECB's efforts to avoid a period of zero growth and inflation have pressured the euro downward since it peaked in March.

The chart below shows the price of CurrencyShares Euro Trust (FXE), a fund designed to track the price of the euro. The 133 level provides major support. It it breaks, expect increased selling pressure.

FXE Chart
FXE data by YCharts

Meanwhile, the U.S. dollar could benefit by not only a weakening euro -- the euro accounts for 57.6% of the U.S. dollar index -- but also strength from the U.S. economy.

U.S. inflation data are released on Tuesday, which should show a continuation of improving core inflation in the country. On Tuesday, the U.S. is expected to release the June consumer price index figure, with market expectations for an uptick of core inflation, which outstrips volatile components such as energy and food.

Unlike Europe, in the U.S. core inflation is approaching the 2% annual target set by the Federal Reserve. An improving labor market and manufacturing sector are expected to put further pressure on U.S. prices in the future.

 

U.S. economic data courtesy of TradingEconomics.com

BofA Merrill Lynch's BAC MacNeil Curry said in a note to clients earlier this month that U.S. five-year Treasury yields are set to move upward and the U.S. dollar should follow suit. He believes that for much of 2014, "U.S. rates and most FX markets have been characterized by range-bound, choppy trading conditions and a relentless decline in volatility. Technical analysis says that these conditions are about to give way to a more directional environment and higher volatility."

As for five-year yields, Curry expects "a breakout to the topside for 2.02%/2.05% and beyond."

UUP Chart
UUP data by YCharts

At the time of publication the author had no position in any of the stocks mentioned.

Follow @macroinsights

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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