The Dollar Breaks To The Upside - How High Can It Go?

Summary

• A bear market in the greenback in 2017.
• An upside correction is underway.
• Fundamentals and technicals could push the dollar index even higher.
• The administration does not favor a rally in the dollar.
• The long-term picture does not look bullish.

The dollar is the world’s reserve currency, and that means that central banks all over the globe hold the U.S. currency as one of their primary foreign exchange assets. The value of the dollar comes from the full faith and credit of the United States government. A long history of stability and the leadership role in the world when it comes to monetary policy makes the dollar a store of value. However, the dollar’s value moves higher and lower over time based on political and economic events and trends. When it comes to the values of comparative currencies, it is often interest rate differentials that determine the path of least resistance for the value of a foreign exchange instrument.

The dollar climbed higher against other world currencies beginning in May 2014, and it reached its highest level since 2002 by January 2017 when the dollar index found a peak at 103.815 on the nearby futures contract. The rally in the dollar was the result of increasing yield differentials between the U.S. currency and the euro and Japanese yen. However, the dollar index ran out of upside gas and had spent much of 2017 in bearish mode.

A bear market in the greenback in 2017

What appeared to be a correction in the value of the dollar over the early months of 2017, turned from a full-fledged correction to a bear market in the greenback. Source: CQG

As the weekly chart of the U.S. dollar index highlights, the index fell after reaching a high of 103.815 in the early days of January 2017. The value of the dollar against other currencies declined steadily through the year and in late August and early September it fell below critical support at the 2016 low of 91.88. The decline in the dollar was the result of prospects for higher European interest rates as quantitative easing by the ECB appears to be concluding. Moreover, with rates in Europe and Japan at negative 40 basis points, the odds favor higher rates in the months ahead. At the same time, the U.S. administration has not been following a strong dollar policy as in the past; instead, both President Trump and Secretary of the Treasury Steve Mnuchin have been advocating for a weaker greenback to spur a more competitive global landscape for U.S. companies. A lower dollar tends to favor U.S. exports.

The dollar index fell to a low of 90.99, but has since recovered and was trading around 94.80 as of Friday, November 3 after reaching a high of 95.06 on October 27, and an upside correction in the dollar has been underway in October.

An upside correction is underway

It seems the dollar index found a bottom at the September 8 low of 90.795 on the nearby December futures contract. Source: CQG

The dollar index bounced higher from the September 8 low, and it did something it had not been able to since the very beginning of this year. For the first time in over ten months, the dollar made a new high on the daily chart breaking the pattern of lower highs in October when it moved above short-term technical resistance at 93.84 on the December dollar index futures contract. The dollar rebounded as the U.S. Federal Reserve took a particularly hawkish tone over recent weeks. The Fed told markets that twelve of sixteen members of the FOMC favor another twenty-five basis point rate hike before the end of this year, likely at the December meeting. At the same time, eleven of the sixteen members of the committee believe rates will rise by twenty-five points three times in 2018. Moreover, the Fed began their program of “balance sheet normalization” in October to reduce the swollen balance sheet from $4.50 trillion which is the legacy of the quantitative easing that followed the 2008 financial crisis. The Fed told markets that debt securities would roll off at a rate of $10 billion per month commencing in October and would increase by $10 billion each quarter reaching a maximum of $50 billion per month. Perhaps the most hawkish position taken by the U.S. central bank is that the process of what amounts to quantitative tightening would not be data dependent, it will be a rote exercise. At their meeting last week, the Fed changed its language when it comes to economic growth from “a moderate pace” to a “solid pace.” The nuance in Fed-Speak reflects a central bank that is acknowledging an improving economy. Last Friday the latest employment report that told market unemployment has declined to a 17 year low was another sign of economic strength. The hawkish tone and plans of the U.S. central bank caused the divide between U.S. and Europe’s interest rates to widen and at the end of last week; the ECB did their best to bolster the case for the U.S. dollar to move even higher.

Fundamentals and technicals could push the dollar index even higher

Recently, ECB President Mario Draghi told markets that while the central bank will trim the amount of QE over coming months, interest rates will remain at the negative forty basis point level. The market interpreted the ECB chief’s comments as particularly dovish as they expected Draghi to spell out plans for tapering QE and begin increasing short-term rates. However, Draghi stressed the need for gradual changes to monetary policy because the inflation rates remain below the European central bank’s 2% target rate.

The bottom line is that U.S. rates continue to increase and Europe is dragging their feet when it comes to a shift from accommodative monetary policy. As the gulf between rates widens, the dollar index where the euro-dollar relationship accounts for around 60% of the value of the instrument has moved to the upside trading at the highest level since mid-July last on October 27 and was trading not far below that level on November 3.

The administration does not favor a rally in the dollar

One of the legacies of past Presidents in the United States has been the strong dollar policy. The U.S. currency is the reserve currency of the world, and a strong dollar is a reflection and validation of the power of the U.S. as the dollar derives value only from the full faith and credit of the United States government. However, the new administration which is anything as typical and business as usual in Washington DC has vocally shunned the strong dollar in the interest of their America First policy when it comes to trade. The fact is that a higher dollar tends to stifle the competitive nature of U.S. goods and exports in the global arena and President Trump has made it clear that he wants U.S. business to thrive domestically and around the world.

It is likely that trade policies that favor a reset of international trade agreements and the potential for punitive tariffs could weigh on the value of the dollar and stand in the way of further gains in the weeks and months ahead. An administration that refuses to follow a strong dollar policy is not bullish for the greenback in the long run.

The long-term picture does not look bullish

The longer-term picture for the dollar continues to be a concern when it comes to the path of least resistance for the U.S. currency. Source: CQG

As the quarterly chart of the dollar index highlights, it has been making lower highs and lower lows since 1985. From 1985 through 1992 a seven-year bearish trend took the greenback lower versus other world currencies. From 1992 through 2001 a nine-year bullish trend caused the greenback to recover to a lower peak. Then, from 2001 through 2008, another seven-year period of the dollar’s descent followed. The most recent rally in the dollar may have run its course from 2008 through early 2017 following the pattern of prior years with a nine-year bullish move. The index found another lower high at 103.815 this past January, and if the trend of trading in the greenback continues, we could be heading for at least seven years of bearish price action in the U.S. currency taking it to a level below 70.805, the January 2008 low in the index.

The dollar broke to the upside on the short-term daily chart over recent sessions, and resistance at the 93.84 and 91.88 levels have become areas of technical support. However, currencies rarely move in a straight line, and the long-term picture suggests that the current bounce in the greenback will not last for too long. The next area of technical resistance for the dollar index stands at 96.065, the July 5 high and at 97.30, the June 20 peak on the December dollar index futures contract. While the ECB continues to take a gradual approach to changing their direction when it comes to monetary policy, rates in Europe are still at historical lows at negative 40 basis points, and QE will come to an end sooner rather than later. Once the market gets a dose of hawkish statements and action from the ECB, it is likely that the administration in Washington DC will get its wish and the dollar will resume its downward path. The long-term picture for the dollar remains bearish, and only a move above the January highs at 103.815 on the dollar index would negate the current trend in the greenback.

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Analyst’s 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.

The author always has positions in commodities markets in futures, options, ETF/ETN products, and commodity equities. These long and short positions tend to change on an intraday basis.