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The financial crisis of 2008/2009 ended a long-term downtrend in the U.S. dollar (NYSEARCA:UUP). Ever since then, the Federal Reserve has been unable to grease the skids sufficiently to get this trend to resume.

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The U.S. dollar has churned in a wide range since bottoming with the 2008/2009 financial crisis

In the chart above, I have noted where the Federal Reserve instituted the last two quantitative easing (QE) programs. QE2 was telegraphed at Jackson Hole in late August, 2010 but initiated in November of that year. QE3 was not telegraphed as directly as QE2, so I am using the day before it was officially announced on September 13, 2012 as the QE3 price. QE2 effectively capped the U.S. dollar until this summer when the dollar index briefly broke through the QE2 cap. I have written earlier that I thought this event would add motivation to the Federal Reserve to ease again at some point. The next question is whether QE3 can effectively lower the cap on the U.S. dollar.

After the Federal Reserve announced QE3, the U.S. dollar dropped for two straight days. It has meandered higher ever since, even recovering all its post-QE3 losses.

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The U.S. dollar has remained resilient post-QE3

Note that the dollar index is still below its 50 and 200-day moving averages (DMAs). I have shown in previous posts the importance of the 200DMA in determining the dollar's next likely direction. In this case, the odds favor a much lower dollar in the coming weeks.

However, understanding how the dollar will decline is quite tricky. The euro is 57.6% of the dollar index, so the euro's direction has a large and outsized impact on the dollar index. The euro (NYSEARCA:FXE) has smartly jumped off 200DMA support against the U.S. dollar, a support level I pointed out in "The Best Currency Setups To Start Q4." If the euro overcomes the highs from September a sustained rally should take flight and bring the dollar index down with it.

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The euro bounces smartly off 200DMA support but can the rally be sustained?

The ECB's bond-buying program has eliminated the tail risk of a break-up of the euro for now, but it is not clear how much higher the euro can or even should go. After all, the periphery of the eurozone is mired in recession. Until these countries uncover some source of economic competitiveness, they will need a lower euro to make exported goods cheaper. Moreover, stresses still exist throughout European bond markets, making the U.S. dollar relatively more attractive.

I pulled the chart below from a September 25, 2012 speech titled "Developments in financial markets, monetary and macroprudential policy" by Paul Fisher of the Bank of England (Executive Director, Markets; Member of the Monetary Policy Committee; Member of the Financial Policy Committee). The chart is a heatmap showing the locus of financial stress in primary and secondary bond markets in the U.S., the euro area, and the United Kingdom from 2007 to 2012. The U.S. is faring much better than the euro area where conditions are tight almost across the board. This means there is a natural force pointing in favor of U.S. dollars over euros. In a sense, this relative demand for U.S. dollars (especially as a reserve currency) allows the Federal Reserve room to print.

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Market functioning 'heat map' based on issuance and spreads data

The Bank of England's Sources: Bloomberg, Dealogic, JP Morgan Chase & Co., Bank of America Merrill Lynch and Bank calculations.
(A) Shading is based on a score that reflects gross issuance (relative to GDP) and spreads in primary markets, and spreads in secondary markets, expressed as a number of deviations from historical averages, using as much data as available from January 1998. Primary market indicators reflect the past three months, to smooth volatility. (Where primary market spreads are not available, mainly affecting the CMBS series in some periods between late 2009 and 2011, primary market indicators are based solely on issuance.)
(B) Updated to end‐August 2012.

Financial stresses also remain relatively high in the United Kingdom as a function of the recessionary economy there and spill-over impacts from the stresses in the eurozone. The British pound is 11.9% of the U.S. dollar index. I have been bullish on the British pound (NYSEARCA:FXB) since it broke out from 200DMA resistance in late August after the London summer Olympics (see earlier posts). I am now neutral as the pound struggles to overcome highs from late April. A breakout should indicate that the Bank of England's recent Funding for Lending Scheme (FLS) is working to relieve stresses in the U.K. financial system; this would renew my bullishness for the pound. In the meantime, I am on the look-out for a pullback to support around the 50 or even 200DMA.

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The British pound is struggling to make new highs for the year versus the U.S. dollar

The Japanese yen is another 13.6% of the U.S. dollar index. While the U.S. dollar is grinding ever so slowly lower against the Japanese yen (NYSEARCA:FXY) since a brief peak in March, it seems very likely the Japanese financial authorities will try another intervention if the 78 level breaks down decisively. A break to new historic lows on USD/JPY is almost certain to generate a response. In other words, the yen's contribution to a lower dollar seems tightly capped. I have discussed these prospects in earlier posts.

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The U.S. dollar grinds slowly lower against the Japanese yen

The euro, the pound, and the yen account for 83.1% of the index. Given the near-term catalysts discussed above for these currencies, it seems unlikely the dollar will experience a strong downward pull in the near-term despite its position below the critical 200DMA (see "The Best Currency Setups To Start Q4″ for my comprehensive outlook for setups this quarter). This suggests more meandering until a fresh, strong catalyst emerges. Friday's jobs report did not provide such a catalyst; it generated a lot of intra-day volatility, but the dollar index essentially went nowhere.

Finally, the announcement of QE3 still marks the 52-week and near 5-year high in the S&P 500 (NYSEARCA:SPY). The stock market is almost behaving as if it will need the dollar to resume its descent to regain/sustain upward momentum (I have used the Australian dollar as a related indicator of the S&P 500′s likely direction). Note that the trend still highly favors the stock market with higher highs and higher lows since the June 1st bottom that roughly follow the upward sloping 20-day moving average (DMA).

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The S&P 500 has made little progress since QE3 was officially announced

Chart source

In summary, while the U.S. dollar index should have a lower bias, the catalysts have not yet arrived to force the issue. Until then, it makes sense to evaluate dollar currency pairs on the individual merits rather than as plays on overall directional expectations for the dollar.

Be careful out there!

Disclosure: In forex, I may initiate a position in any of these currency pairs, short or long, at anytime. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: The U.S. Dollar's Post-QE3 Relief Rally Likely To Give Way To Meandering