On Tuesday, the remarkable turnaround of the U.S. dollar (NYSEARCA:UUP) was completed when the dollar index returned to its pre-election level. Whilst the fall from grace for the dollar index may have come as bit of a surprise to some traders, we felt this was an inevitability. Furthermore, we think there is the potential for the index to drop lower still. Because of this, we would caution traders from opening dollar long positions at this point in time, no matter how tempting it might be.
When you look at the chart above, it becomes apparent just how far the dollar index has fallen. By our calculations, the index has fallen approximately 5.5% from its post-election high as the Trump trade fades and the economic outlook in the United States softens. But it is worth remembering that it isn't all down to Trump. Sure, his inability to push policies through and his talking down of the dollar has played a big role in its decline, but there are other forces at work here as well.
As you can see below, the dollar index is not an evenly balanced basket of currencies. It is heavily weighted towards the Euro (NYSEARCA:FXE).
With a 57.6% weighting, the performance of the Euro has a major say in how the index performs. This is very clear to see when we expand the chart and add in the Euro as well, as you'll see below.
While the other currencies in the basket certainly can impact the dollar index, the reality is that it is what happens with the EUR/USD pair which has the greatest impact. Hence, why the two assets have an almost perfectly negative correlation. This further explains why the dollar index has weakened considerably in recent weeks. The euro has rallied by 4.5% since this time last month thanks largely to the result of the French election and positive economic data.
We think this run can continue, especially when you consider the opposing views of Donald Trump and Angela Merkel on their respective currencies. In one corner, you have Trump talking down the dollar, saying it is too expensive. And in the other corner, you have Merkel stating that "the euro is too weak."
And we agree with Merkel. Considering the positive economic data coming out of the Eurozone, we feel the Euro, which is the best-performing currency in the developed world, still has a lot of gas left in the tank.
While we're not about to boldly forecast that the EUR/USD pair is about to rocket to pass 1.2 any time soon, we do see reason to believe that it could rise as high as 1.14 to 1.15 this year.
One only needs to look at the positive revisions to the Eurozone's economic growth this year to see how sentiment is shifting positively. From 1.3% growth at the start of the year, the consensus is now for 1.7% growth in the region this year.
We expect this positive economic growth and its rising inflation levels could allow the ECB to raise its interest rates this year. Whilst we view this as an outside chance at this stage, if the positive data keeps rolling in, then there's potential for a surprise. At present, we don't believe the possibility of a rate rise being priced into the Euro, providing an extra bit of upside potential later this year. The U.S. dollar, on the other hand, has an 83.1% probability of a rate rise in June priced in at the moment. Because of this, we don't think a rise will move the needle a great deal.
In our opinion, this all adds up to a weakening U.S. dollar index. By our calculations, we forecast the UUP falling to around $24.50 by the end of the year. Which is around 2.6% lower than where it trades today. With leverage, this could arguably be a decent short trade, but that's not necessarily the main point we are making today. Rather, our view is that the dollar index may have fallen sharply recently, but that doesn't automatically make it a bargain buy. We would suggest investors hold off initiating a long position in the dollar index for the time being as further weakness could yet form.
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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.