U.S. Dollar Index - A Contradictory View - Major Inflection Point

by: Chris Markouizos
Summary

U.S. Dollar Index - S&P 500 - one true unclear relationship and their ever-changing correlation.

Capitalizing Cycles - The 7.8-year U.S. Dollar Index Cycle has been completed. It's time for the next one.

Interest Rate hike must strengthen the currency - Or not?

U.S. Dollar Index Structural Confluence Analysis- Elliott-Wave.

A weak dollar usually coincides with an upward trend in the equity markets and vice versa. The fundamental reasons for this relationship are straightforward and among them is the observation that a falling dollar makes the price of U.S. products more attractive abroad, increasing exports for U.S. firms.

The consensus view is that a rising USD is bearish for the stock market whilst a falling dollar is bullish, thus negative correlation.

However, If you think that you know the one true relationship between the stock market and the value of the dollar, you are going to find yourself wrong about half of the time.

The following chart illustrates the correlation between stocks and USD.The shaded boxes show periods in which, like this year, the dollar-stocks correlation has been inverse.

  • The earlier trend of the mid-1990's shows a conflicting picture where for significant lengths of time the dollar and stocks both trended in the same direction, usually both upwards which coincides with periods of strong economic growth when the U.S. was a favored investment destination thus demand for US assets and stocks was high. Positive correlation
  • When the S&P began its new uptrend from the March ’09 low, the US dollar began to weaken again. The dollar dived -18.8% forming a secondary low on May ’11. - a huge move that seems logical enough! But the risk-on/risk-off strategy disengaged afterwards with the dollar gaining a massive +42.8% into this year’s January ’17 peak whilst during the same period, the S&P gained 82.4%. Positive correlation.
  • Amongst the world currencies, the USD is quite perceived as a ‘safe-haven’ currency. During times of uncertainty or financial stress, the U.S. dollar index strengthens against its G10 trading partners. This was certainly the case during the last two major financial crises. Firstly, when the S&P declined -50% during years 2000-2002 and then secondly, by -57% during 2007-2009. In the first case, the U.S. dollar only managed a gain of +8% but +27% during the Lehman-crisis. Negative Correlation

Why does that matter?

As history shows, the USD and the stock market move in the opposite direction but there are also equal times, when the stock market and the USD both move up - usually times of economic recovery, whereas what's uncommon, is to see both the stock market and the USD moving down together. That has only happened a handful of times over. The ever-changing correlation between the USD and stocks suggests that the issue of trying to quantify the degree to which these two are positively or negatively correlated at any given time might be pointless. So even if your current outlook is somewhat restricted and oriented to the consensus view, try to think out of the box.

From the above, we gain a glimpse of how the dollar performs, but is there a way to predict its next major direction?
What triggers its directional move? Is it going to strength on further Federal Reserve interest rate hikes? Is it going to strengthen basis another stock market crash or at a possible U.S. economic expansion? Either way, it seems that we should not even examine the opposite direction, that of a weakening U.S. dollar, considering the current bullish drivers in place – or should we?

Forecasting Major Inflexion Points

An Inflection Point is: "An event that changes the way we think and act."
- Andy Grove, Founder of Intel Corporation.

Inflection points, both bullish and bearish, repeat themselves over and over again. All you have to do is be patient and disciplined enough to wait for the next. Often it seems it happens, too fast and all at once. It takes practice and a strong ‘emotive’ but objective conviction that an opportunity is waiting. But not all major inflection points are so obvious – some begin quietly, almost unnoticed as marketplace can be slow which means we have to use tools to identify these.

Cycle Forecasts

A cycle is something that influences the price movement of a financial market to move up towards a peak, and then to move down towards a trough. It repeats that action on a fairly regular basis.

No worries I’m not going to unfold sheets of paragraphs to master the cycle theory concept. However, in order to understand the reason why it is mentioned in this article, it’s essential to know how it can provide us an orientation and perspective about USD direction.

  1. If we perform a cycle analysis and know what each of the cycles is doing right now, then...
  2. We know what they will be doing in the near future (because cycles are fairly regular)
  3. And therefore we can calculate the sum total effect of all longer cycles for the next iteration of our trading cycle…
  4. And hence we can predict the shape of the next iteration of our trading cycle

And knowing the shape of the cycle means that we can trade it!

It’s hard to argue that the U.S. Dollar Index is unfolding to the rhythm of a 15.6-year Cycle which connects peak-to-peak, trough-to-trough

The following chart illustrates the 15.6-year Cycle of U.S. Dollar Index Weekly Chart (log scale)

The alternating 15.6-year cycle is composed of a near-centrally translated 7.8-year interval from peak-to-trough-to-peak etc. That means the last cycle-trough traded in March 2008 was due to peak next in Q1/Q2 2016. It was a little late which is due to the fact that the centrally translated rhythm is not exact but its close enough. Peaks and troughs in price do not occur at the same time as those peaks and troughs in the actual cycles.

The following chart illustrates the 7.8-year and the 15.6-year Cycles of U.S. Dollar Index Weekly Chart (log scale)

The above chart is a simple Cycle analysis combining 2-cycles, however, it could give us a lot of insight into the direction of the U.S. dollar.

So what can someone derive from the USD Cycle Analysis?

One thing is clear. This major cycle-peak (January '17) has been completed. We, unfortunately, can't determine for sure why the USD should begin a new 7.8-year cycle decline – we can, of course, hypothesize, but the outcome can often be totally different. So many times in the past have we saw a different fundamental/economic reason unfold than we thought and yet still validating the structural price-time confluence.

Interest Rate hike must strengthen the currency. Or not?

Roger Blitz writes in the Financial Times:

Betting on a stronger currency sounds sensible, particularly when market interest rates and inflation expectations are rising.

It's a consensus view that an interest rate hike should increase the currency's strength due to their positive correlation. On the premise that inflation was returning and therefore U.S. interest rates would rise, and also the expectation of three more rate hikes this year, despite the fact that the Federal Reserve has raised the interest rates five times over the past two years, the U.S. dollar's strength should have been undeniable. So why not extrapolate a stronger USD?

The problem comes if Trump manages to reverse the previous administration’s strong dollar policy. Trump is achieving a weaker USD at the same time with big tax cuts and protectionist rhetoric, both of which should boost the USD. However, it's not the first time that USD and interest rates have this passive or even inverse relationship. In the early-1970’s, the de-pegging of the USD/gold relationship brought an end to the Bretton Woods currency system and with it, a declining USD over the next decade whilst interest rates ran exponentially higher. That same era or cycle is about to emerge again.

Trading success often means training oneself to think outside the box – knowing when to detach from the herd and run against it – to become the independent free thinker, trader.

Elliott-Wave Analysis

Analysis of this 8-year dollar upswing March ’08 – January ‘17 is confirming the advance as ending a counter-trend pattern.

The following chart illustrates the U.S. Dollar Index (DXY) Weekly Chart (log scale)

Source: tradingview.com

The March ’08 advance is labeled as a corrective upswing, a Zig-Zag pattern. Using Fib-price ratio model for this pattern combined with internal price measurements, we have three fib-price ratios converging, heightening the probability that the five-wave sequence (i)-(v) has ended within the last C-wave (circle) of the corrective Zig-Zag pattern indicating the closing of the cycle. The end of the larger degree second-corrective wave 2 (square) at 103.82 (=61.8% of (1 square)) is paving the way for the larger trend continuation.

After the completion of the internal fourth-wave correction (iv) of C(circle) which took the form of a triangle, price traded upwards with a 5-wave sequence till January 2017 high at 103.82, responded lower afterwards and has been declining since. Is this the case, then the scenario for the A-B-C (circle) Zig-Zag completion is corroborated as a triangle always occur in a position prior to the final actionary wave, in our case ((v))-wave.

Having confirmed the reversal signature and witnessing a five-wave (i.-v.) price event coming to its completion labeled as 1, we have set our price target at 88.70(+/-) awaiting a reversal from that point, and price to go through some retracement rise lasting even many months as it's usually deep.

The completion of this corrective wave will trigger the main downtrend continuation.

Conclusion

When the answer is obvious, then decisions are easy. It's when the answer is not clear that we have a very different set of conditions. These two disciplines, Elliott Wave and Cycle Theory are confirming the USD ended its 7.8-year advance which encompassed the financial crisis and U.S. economic expansion. If you think about investing in USD in 2018, that might be a good idea as this will be a recovery phase for the dollar. However, longer term it seems that the U.S. dollar’s value will face tough years ahead.

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.