What Would Make This Dollar Bull Nervous

| About: CurrencyShares Euro (FXE)

Summary

USD had a large rally in November.

We had been looking for a short and shallow pullback.

Here are thoughts about what would signal an outright correction.

The Federal Reserve's real broad trade weighted dollar index rose 2.3% in November. This is the largest monthly advance since September 2011. This is the measure that officials and economists use to try to assess how the currency movement impacts financial conditions and the economy.

The recent string of economic data has been generally better than expected. Not only will Q3 GDP likely be revised up again, but many economists are revising up their forecasts for the performance here in Q4. The market fully discounts one rate hike next year, and is well on its way to discounting a second hike as well. While two hikes are beginning to seem the consensus as next year's forecasts are constructed, a third hike looks more likely than just one. In any event, no other major central bank will be able to keep pace with the Fed.

In addition to the continued policy divergence, European politics and the risk of another victory for the populist-nationalist forces may also weigh on the euro. Three elections are planned - Dutch, French and German - but the probability of a British, Italian and Austrian election is above zero. We have argued that many investors may be focused on the wrong event this weekend (Italy instead of Austria) and the same may happen next year too. Investors seem more concerned about France and Germany, while the populist-nationalist Freedom Party is running ahead in the Dutch polls.

The US Dollar Index (DXY), which is not a trade-weighted basket, but a tradable basket of foreign currencies heavily weighted toward Europe. The three-week advance is at risk. It is off about 0.25% and there is still tomorrow's US employment data to digest. However, we anticipated a shallow dollar pullback and so far that is what has materialized.

We also expected the pullback to be short-lived. For that the jury is still out. What would suggest a deeper correction is a break of 100.65. That is the low from November 22 and November 28, and looks to be the neckline of a potential topping pattern, perhaps a derivative of a head and shoulder pattern. A break would likely be the first sign that the consolidation is turning into an outright correction. The first target would be around 99.70, the 38.2% retracement of the post-election dollar rally. However, the potential topping pattern would have a measuring objective of closer to 99.00, which corresponds to a 50% retracement of the post-election dollar rally.

To be clear, this is not about my longer-term outlook for the US dollar. It is about a near-term tactical scenario, not the long-term strategic view.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.