The Dollar Bounce: The Beginning Of A Recovery Or A Dead Cat?

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Includes: AYT, BZF, CEW, CNY, CROC, CYB, DBV, DRR, ERO, EUFX, EUO, FXA, FXB, FXC, FXCH, FXE, FXF, FXS, FXSG, FXY, GBB, ICI, INR, JEM, JYN, PGD, UDN, ULE, URR, USDU, UUP, YCL, YCS
by: Andrew Hecht
Summary

The rally that began in May 2014 comes to an end after huge gains.

A one way market since January 2017.

The dollar falls despite interest rate differentials.

The August 4 jobs report causes a rally.

Three reasons why the dollar will fallbelow technical support after the rebound runs out of steam.

The dollar is the reserve currency of the world because the world perceives the United States as the most stable country on earth. The U.S. is also the richest nation, which tends to go hand-in-hand with stability. Central banks around the world hold dollars as a reserve asset because it has been a store of value for decades, if not longer.

The U.S. is a leader in the world, and many often think of the President as the leader of the free world. In the wake of the 2008 financial crisis, it was the U.S. Federal Reserve’s handling of the economy via the use of monetary tools that served as a model for many other countries. The European Central Bank adopted policies of slashing interest rates to historic lows and quantitative easing via buying debt to avoid recession or worse. Even though the U.S. has moved towards tightening since late 2015, those policies remain in place in Europe. The bottom line is that the U.S. is both a military and economic powerhouse and its currency is in a class by itself.

The success of U.S. monetary policy led the dollar to appreciate starting in May 2014, and the U.S. currency moved an astonishing 31.5% higher by January 2017.

The rally that began in May 2014 comes to an end after huge gains

The appreciation of the U.S. dollar over a two and one-half year period was impressive. Source: CQG

The bulk of the move in the U.S. dollar index occurred in the first ten months as it appreciated from lows of 78.93 in May 2014 to highs of 100.38 in March 2015. The over 27% rally happened in a flash when it comes to normal moves in the international currency markets, particularly when it comes to the reserve currency of the world. The rally in the U.S. currency was the result of the end of quantitative easing and prospects for tightening rather than accommodation. Interest rate differentials tend to drive currency prices and the Fed’s intention to taper QE in 2014 and hike rates in the future signed the end of accommodation. The dollar moved to the upside against the euro, yen and other currencies as the market perceived that the dollar would offer a more attractive yield. Over the next twenty months, the dollar index consolidated from 92 to just over the 100 level reaching a high of 100.60 on a false upside breakout in November 2015. QE came to an end, and the Fed began hiking the Fed Funds rate in December 2015, but the dollar remained in its trading range. However, in the aftermath of the election of Donald Trump last November, optimism about fiscal stimulus drove the currency to the highest level since 2002 at 103.815 on the nearby dollar index futures contract. Then, the music ended, and the bull market in the dollar came to a screeching halt.

A one way market since January 2017

The dollar moved quickly from bull to bear after reaching its peak at the very beginning of 2017. Source: CQG

As the daily chart illustrates, the index reached its most recent low on August 2 at 92.39, a decline of 11% in seven months. The dollar has been a one-way street in 2017, and it has dropped to a level where it is now threatening to test critical supports at the May 2016 at 91.88 and the midpoint of the move from May 2014 to January 2017 at 91.372. The index has made lower highs and lower lows throughout the year, but during the month of July, the U.S. currency was in free fall.

The dollar falls despite interest rate differentials

The dollar rallied starting in May 2014 on the prospects of higher interest rates and tightening credit. However, it fell less than one month after the Fed hiked interest rates for the second time in December 2016 and kept falling even though the central bank has increased the short-term rate twice more in 2017 and told markets they plan to normalize their balance sheet. The Fed’s balance sheet had swelled to $4.5 trillion, and the legacy of QE will soon start rolling off to the tune of $50 billion per month. The unwinding of QE is effectively QT, quantitative tightening. Moreover, the central bank has indicated they plan to hike rates once more in 2017 and three times in 2018. Right now, European and Japanese short-term rates are at negative 40 basis points. Therefore, the U.S. dollar yields 165 basis points more than the euro and yen and will likely yield 190 basis points more by the end of 2017. On paper, the dollar looks a lot more attractive than the euro or yen currencies at this time, but Europe is presently showing signs of coming out of its economic funk and stability has returned to the European Union.

Election results from France and the Netherlands in 2017 were an about face compared to the Brexit debacle in 2016 that threatened the very existence of the Union and the euro currency. In September Germans will vote on whether to give Chancellor Angela Merkel a fourth term and she looks as close to a sure thing as one can these days when it comes to elections around the world. A victory by Merkel next month would amount to a clean sweep for the pro-European Union camp, and that has caused a rebound in the currency against the dollar. At the same time, economic conditions have improved, in part because the depressed euro currency has stimulated the economy. Over recent months, ECB President Mario Draghi has told markets that tapering of QE is on the horizon and rates will begin to gradually rise in Europe. It was those statements from the Fed that led to the 27% rally in the dollar starting in May 2014, and the euro currency has exploded to the upside from the lowest level since 2002 in December 2016. Source: CQG

As the monthly chart shows, the euro currency has rallied from lows of $1.03675 against the dollar last December to highs of $1.19395 in early August. The euro has appreciated by over 15% and is closing in on the $1.20 level.

The trajectory of the move higher in the euro currency and lower in the dollar pushed the currencies into an overbought and oversold condition respectively and both were in desperate need of a break after huge moves. The break came on August 4 when U.S. economic data stopped the dollar from falling off the edge of a cliff.

The August 4 jobs report causes a rare rally

The jobs report on August 4 was positive for markets and the dollar rallied when the news that both employment and wages grew more than the market had expected. The dollar turned around and moved higher in the wake of the jobs release. Source: CQG

As the daily chart of the dollar index shows, the dollar has bounced from the August 2 lows at 92.39 to highs of 93.785 on August 9 and was trading at the 93.50 level at the end of last week. Technical resistance for the greenback index is at 94.115, the July 26 highs, and at 96.225, the July 5 peak in the index. Time will tell if the move in the dollar is the start of a recovery in the U.S. currency or just another dead cat bounce in the dollar.

Three reasons why the dollar will fall below technical support after the rebound runs out of steam

There are currently three reasons that favor a return to the lows in the dollar index and a break below critical support levels that will end the bull market that started in May 2014.

First, currencies tend to trend in one direction for long periods. Source: CQG

Momentum on the monthly chart of the dollar index remains lower, so from a technical perspective, the dollar has not yet found its low.

The second reason that the dollar is likely to move lower from its current level against the euro and other currencies is that Europe is preparing to taper QE and will eventually begin the process of increasing their short-term interest rates. The dollar rallied by 27% when the Fed began the process in the United States. While the euro is already 15% higher than its December 2016 low, a similar move in the European currency would take it to over the $1.30 level against the dollar forcing the dollar index much lower than its current level.

Finally, events in Washington DC favor a weaker dollar. The greenback rallied following the Presidential election on optimism for health care, tax, immigration reforms and infrastructure building. More than six months into the new administration it has been business as usual in Washington as the Congress has not been able to turn any of President Trump’s campaign pledges into legislation. Even though the administration has majorities in both the Senate and House of Representatives, gridlock has prevented any movement on the legislative front. Moreover, President Trump and his Treasury Secretary Steve Mnuchin have made no secret in their desire to see the dollar fall against other currencies. A lower dollar makes U.S. exports more competitive on global markets and will improve the trade balance. Therefore, rather than a strong dollar policy, this administration favors a weak one.

The jobs report on August 4 breathed some life into the dollar, but it is not running away on the upside. The current state of the foreign exchange markets could be telling us that the dollar is heading lower over coming weeks and months which will have consequences for markets across all asset classes. When it comes to the commodities markets, a break below critical support at the 91.88 and 91.372 levels on the dollar index could ignite a huge move on the upside as raw materials become cheap in other currency terms and are already starting to show signs of an impending rally. Time will tell if the recent uptick in the dollar was the beginning of a recovery rally in the U.S. currency or just a dead cat bounce. I believe that even if the dollar can work its way to 95 or 96 on the dollar index, we are going to eventually see it break to the downside as the euro’s path of least resistance appears to be higher.

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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.