The U.S. dollar broke above a significant level of technical resistance after seven months of consolidating between 92 and 97.61 on the November dollar index futures contract on Tuesday, October 11, 2016. The dollar did not wait for two significant events. First, the November 8 election that will decide the next President of the United States has weighed on the greenback. Memories of a Brexit vote in June that drove the pound from $1.50 to under $1.30 against the dollar are an example of what a surprise election result can do to a currency market. However, the case may be that when all is said and done, the election results will trigger a rally in the dollar regardless of who wins the contest.
The second momentous event for the dollar will be the last meeting of the Federal Open Market Committee of the U.S. central bank. At last glance, over 60% of the market believes that the Fed will hike rates by 25 basis points at their December meeting, down from 80% in the prior week. The Fed minutes released on October 12 were surprising in that while the market knew there were dissenters at the September meeting, there was no indication of whether the Fed is ready to act in December. In fact, the Fed changed its language from "imminent" to " reasonably soon" when it comes to the next rate hike. In Fed speak; there is a world of difference between the two. In a comment on another article I wrote last week, one commenter suggested that the next words of choice for the central bank will be "definitely maybe." With interest rates in negative territory in Europe and Japan, the odds are that any interest rate hike would fuel the dollar to rise and head for above the 100 level on the dollar index, the highs of last year. Meanwhile, the dollar broke above critical resistance last week but the Fed minutes sent it back below.
The long consolidation in the greenback
Last week, the dollar index traded to highs of 98.12 on the December futures contract and closed the week just under 98 at 97.997. As the weekly chart highlights, the dollar index traded to the highest level since the week of March 7, 2016. The dollar rallied above the 97.61 resistance as market consensus increased for the first interest rate hike by the U.S. Fed in 2016 at their December meeting. The dollar had been on a one-way path since August when it traded to lows of 94.05. The daily chart illustrates the over 4% rally in the U.S. currency over a two month period. When the Fed released minutes from their September meeting on Wednesday, the dollar index stopped in its tracks which may be good news for the central bank if they do wish to hike in December. After all, a stronger and raging greenback would make it very hard for the Fed to increase rates without making the U.S. currency a rocket ship. On Thursday the dollar index closed at 97.518, just below the bullish breakout level and on Friday it recovered to close above the resistance level. However, the Fed minutes curbed the enthusiasm of the dollar.
The dollar has been making higher lows and higher highs since May
As both the daily and weekly charts of the dollar index show, it traded to the lowest level of 2016 in May when it hit 91.88 on the active month futures contract. Since May, the dollar has been moving progressively higher. Each time the market believed that the Fed was getting ready to hike rates, it would rally, and when the central bank disappointed markets by kicking the can down the road, it turned south. However, the lows have been higher and the highs have been higher over the past seven months leading to a technical move last week that pushed the top end of the trading range to a higher peak. The dollar's break above a level that represented more than a half-year high was a major technical event.
The technical breakout was significant
Since the end of September many speculators, investors and traders have been hopping aboard the bullish dollar train. While momentum crossed to the upside on the dollar at the beginning of October, open interest increased from 47,964 contracts on September 19 to 74,939 contracts at the end of last week. Open interest is the total number of open long and short positions on the dollar index futures contract. The dollar index is a reflection of the extremely liquid over-the-counter currency markets. The increase of over 56% in open interest, while the dollar was appreciating, provides technical validation for the move and trend in the dollar as well as the break above a critical resistance level.
Where will the U.S. currency go - short, medium and long-term?
The dollar is now sitting at new highs, for the time being. It is likely that profit-taking and position squaring going into the election could take the U.S. currency back down to the 96 level on the December futures contract over the next three weeks. From a medium-term perspective, it appears that the dollar's pattern of higher peaks should remain intact. The dollar is still the world's most stable currency and the most highly sought reserve currency.
In the long term, which I will define as 2017 and beyond, it is almost impossible to make a bearish case for the dollar. I am not a fan of all paper currencies because of eight years of accommodation, but the dollar remains the best option in a class of very poor choices. European quantitative easing and negative interest rates will continue to weigh on the value of the euro. The British pound could be heading toward parity against the greenback as the nation works its way out of the European Union. China continues to devalue their currency, and the Japanese yen is a basket case currency with negative interest rates and low productivity in the Asian nation that will only allow the yen to become a safe haven at times when truly problematic economic or political issues present themselves around the world. Therefore, the path of least resistance for the dollar index is higher, and I expect it to make new peaks and trade appreciably above the 100 level during 2017.
Regardless of the election, the dollar is eventually heading higher
The shocking surprise of the Brexit referendum gave all currency traders around the world reason to pause and be particularly mindful of risk positions going into an election. The pound fell from $1.50 to under $1.30 in the immediate wake of the vote. It has traded at the $1.20 level since.
The most contentious election in modern day U.S. history will take place on November 8, and it is likely to be a risk-off event even though Hillary Clinton is currently leading in the polls. Remember, the no votes on Brexit were leading going into Election Day, so faith in pre-election polling has dropped to all-time lows. A Trump victory would likely cause tremendous initial volatility in the greenback, but over time, the fundamentals for the currency will prevail. Therefore, I believe that regardless of the outcome of the election, the dollar will continue on its medium-term path since May and it longer term trend that commenced in May 2014 when the dollar index was below the 80 level.
The dollar continues to be a beast and the fact that the central bank is even considering hiking rates "reasonably soon" puts it in a class by itself when compared to other paper currencies around the world. The actual value of the dollar is another question, but when contrasted with other foreign exchange instruments, the dollar should already be a lot higher. We will find out a lot about the dollar if commodities like gold ultimately appreciate alongside the greenback as that would be a revealing commentary about the value of paper money.
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This article was written by
Andy spent nearly 35 years on Wall Street, including two decades on the trading desk of Phillip Brothers, which became Salomon Brothers and ultimately part of Citigroup.Over the past two decades, he has researched, structured and executed some of the largest trades ever made, involving massive quantities of precious metals and bulk commodities.
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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.