What's Holding The Dollar Back From Breaking Out

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Includes: DRR, ERO, EUFX, EUO, FXE, FXY, UCO, UDN, ULE, URR, USDU, UUP, YCS
by: Chris B Murphy

Summary

The dollar is down from the January highs and what's ailing the dollar will likely be sticking around.

What's moving the dollar? Yields have retraced somewhat, the Fed is unlikely to hike in March, and Europe may go through a political upheaval.

Watch for upward revisions in U.S. GDP growth which was anemic in 2016 at 1.6% and any sign of inflation for the Fed to hike.

The currency market is an effective barometer for what's driving global investment flows. As investors chase yield from country to country they, in turn, convert their capital to the higher-yielding local currency. As a result, the exchange rate strengthens for the country receiving the flows and weakens for the country from which the flows were withdrawn.

And since yields are hot right now, and look very promising and topical in the near future, currencies and yields should continue to be positively correlated. The yield impact on currencies is sizable making the pair a great team when performing trend analysis and determining your entry point for in an investment.

With U.S. yields surging as of late, we would assume the U.S. dollar has been surging as well, and yet the dollar is only up 5% since the Trump election victory.

If investing in the U.S. dollar via the PowerShares DB USD Bull ETF (NYSEARCA:UUP), or dollar-denominated investments like crude oil via the ProShares Ultra Bloomberg Crude Oil ETF (NYSEARCA:UCO), understanding which specific currencies are impacting the dollar is important to managing your risk and timing your entries.

What's impacting the dollar, the dollar index (DXY), and dollar ETFs:

The dollar is down just over 2% from the highs earlier this year which is not very spectacular considering the Fed has raised rates and President Trump has signaled plans for fiscal expansion. The dollar should be rising since yields, economic growth prospects, and the resulting inflation (leading to Fed hikes) are all dollar bullish.

Since the dollar is not rising despite the dollar bullish events, we must dissect the dollar index to determine which components or currencies of the index are impeding the dollar and how these components impact the rest of the market.

The dollar is down vs. the Japanese yen by over 4% YTD.

The yen is a huge factor in the value of the dollar and of the dollar index since it's one of the most actively traded currencies in the world. Japan is also the third largest economy, behind China and the U.S.

UUP Chart

UUP data by YCharts

The reason for the yen strength and dollar decline is more of a dollar story than a yen story. Uncertainty and frustration is rising in the markets stemming from the lack of details from the Trump administration regarding his stimulus and tax policy. The uncertainty is weighing on the dollar and breeding yen strength due to the yen's safe haven status.

For investors who went long yen (looking for yen strength and dollar weakness) through the CurrencyShares Japanese Yen Trust ETF (NYSEARCA:FXY), they're enjoying a 4% gain YTD. For those who shorted the yen and bought dollars (expecting dollar strength and yen weakness) through the ProShares UltraShort Yen ETF (NYSEARCA:YCS), they saw an ~8% drop in their portfolio.

YCS Chart

YCS data by YCharts

We may get more details from President Trump about his policies during Tuesday's address to Congress. However, the market appears to be coming to terms that the Trump stimulus may turn out to be implemented in the back-half of the year. The delay could force the market to reconsider the timing of growth, inflation, and subsequent rate hikes. Any delay is negative for the dollar.

Falling U.S. yields:

The 10-year Treasury yield has fallen ~6% (in percentage terms) from its highs in early January.

10 Year Treasury Rate Chart

10 Year Treasury Rate data by YCharts

Since the rally in the dollar has largely been the result of rising yields on the back of growth and inflation, any fall in 10-year yields will lead to dollar weakness. On the other hand, the yield rally is long overdue and may not go away quietly. Most investors see a 10-year Treasury yield with a 3% handle as inevitable, and this bullish sentiment for yields may create a floor preventing a serious correction.

For analysis on the key levels to watch in yields, please check out my earlier article. A break below 2.3% (and stay below for a few days) would likely lead to a short-term pull back in yields, and drag the dollar down as well.

Europe is a bright spot for the dollar.

The dollar would be even worse off if the euro didn't weaken. From the graph below, we see the USD rose almost 2% against the euro. Had we not had that gain, the dollar or UUP would be down over 4% (in line with the 4.1% depreciation against the yen).

^DXY Chart

^DXY data by YCharts

Regarding the Chart above: The euro to U.S. dollar drop of 1.84% is dollar strength (euro weakness) and the U.S. to yen fall of 4.1% is dollar weakness (yen strength).

European political issues are weighing on the euro and European equity indices. The Anti-EU French presidential candidate Le Pen gained ground in recent polls. Although Le Pen may win the 1st round, it's unlikely she'll win the 2nd round and even more unlikely France will leave the EU. According to French law, only an amendment to the constitution would allow France to Frexit.

^GDAXI Chart

^GDAXI data by YCharts

Nevertheless, stranger things have happened recently, and despite the arduous political process ahead, the euro and European equity markets appear to be trading off the poll numbers. As a result, watch for an increase in volatility as the election draws near.

Going forward, what should move the dollar:

  • News from Brexit, Trump, and the European political landscape will be key drivers over the next month or so. If European equities continue to fall, the dollar may get a lift and those investors long the euro through the CurrencyShares Euro Trust ETF (NYSEARCA:FXE) will get hurt from the weaker euro.
  • Look for upward revisions in U.S. GDP and for any signs of inflation as key determinants for a Fed hike in May or June.
  • Watch the 10-year yield for any break below 2.3% as a sign that a correction may be imminent. Any yield correction (rally in bond prices) would be negative for equities, especially banks, and ultimately the dollar.
  • Please be careful: For investors already long European equities through international ETFs and funds, you might consider rebalancing your portfolio or employ risk management strategies if the political issues erode European equity indices further.

More to follow on yields, financials, and risk management techniques designed to prevent that dreaded "bad' trade. If you like this article and would like to read more of my market analysis, please click the follow button to the right of my name at the top of this article.

Good luck.

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.

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