The Dollar Reaches The August High - What Took So Long?

Summary

  • The dollar finds a low in February and rises to a high in mid-August.
  • A period of consolidation appears to be ending.
  • Interest rate differentials are bullish fuel for the greenback.
  • A breakout to the upside could lead to volatility in the currency market.
  • So many issues facing the dollar index these days - UUP for those who do not trade in the forex market.
  • Looking for more? I update all of my investing ideas and strategies to members of Hecht Commodity Report. Get started today »

The dollar is the world's reserve currency which makes it the most popular and widely held foreign exchange instrument when it comes to central bank holdings around the world. All of the leading world currencies are fiat money, backed only by the full faith and credit of the governments that issue the legal tender. Central banks and people all over the world perceive the dollar as a valuable currency because of the stability of the United States which has the largest GDP in the world.

The two leading world currencies these days are the dollar and euro. However, it is possible, and maybe even likely, that the Chinese yuan will challenge them for reserve status in the years ahead. The Chinese have been cooperating with the International Monetary Fund to gain greater recognition for their foreign exchange instrument. However, the communist government and economic system present barriers for the yuan even though China is home to the world's second largest GDP and it will not be long before they rise to the top spot surpassing the United States.

Meanwhile, the dollar looks like it is making a move to the upside when it comes to the value of the greenback against other leading foreign exchange instruments. The Invesco DB U.S. Dollar Bullish ETF product (NYSEARCA:UUP) provides an alternative for investors looking to participate in the rise of the dollar against the euro and other world currency instruments.

As the dollar index reached a level that put the greenback at a new high for 2018 this week, the question is what took it so long to get here?

The dollar finds a low in February and rises to a high in mid-August

The dollar index moved to the highest level since 2002 in January 2017 when it rose to 103.815.

Source: CQG

As the monthly chart of the dollar index highlights, the index began a significant decline in early 2017 which led to a low at 88.15 in February 2018, a drop of over 15% from the high. However, over most of 2018, the dollar has been back in rally mode reaching a peak at 96.865 in mid-August, a recovery of just under 10% from the low.

The selling in the dollar came to an end earlier this year, and after the rise to the peak in August, the dollar index entered a period of sideways trading.

A period of consolidation appears to be ending

After trading to the 96.865 level in mid-August, the dollar index ran out of steam and corrected to a low of 93.395 in mid-September.

Source: CQG

As the daily chart illustrates, the index consolidated in a range from 93.395 on the December futures contract to the mid-August peak throughout September and October, but at the end of last month, it began to move towards the high and on the final day it finally climbed above the resistance level at 96.865. The index has made a series of higher lows and higher highs since the September low. Price momentum on the daily chart is rising, but it displays an overbought condition along with the relative strength indicator. Open interest or the total number of open long and short positions in a futures market has been gently rising with the level of the index which tends to be a technical validation of a bullish trend in a futures market. The futures market is only the tip of the iceberg as the OTC foreign exchange market is where most currency trading takes place, but the increase in open interest is a likely reflection of positions in the much larger and more liquid OTC market these days.

The high on the continuous contract was at 96.865, but on the December futures contract, the peak from late summer stood at the 96.45 level. On October 25, the index moved above that level making a new high for the year on the nearby futures contract. On the final day of October, the index traded to a new high at 96.975, the highest level since June 2017.

Interest rate differentials are bullish fuel for the greenback

In the world of foreign exchange, one of the leading factors that determine the path of least resistance of one currency instrument versus another is the differential between short-term yields or interest rates. The euro currency account for 57% of the composition of the dollar index. With another increase in the Fed Funds rate coming at their December FOMC meeting, the gap between the short-term dollar and euro rates will rise to 2.65-2.90%. With the Fed Funds rate at 2.25-2.50% at the end of 2018 and euro rates at negative forty basis points, it pays to hold dollars which offer not only a higher return but a positive yield. Given the level of rates in Europe, holding the euro currency continues to come at not only an opportunity cost but a real expense.

The Fed has been on a gradual program to increase interest rates since liftoff from a zero percent Fed Funds rate in December 2015. Over that period, the European Central Bank has not tightened credit by one basis point. At the same time, the Fed rolled out a program to reduce their swollen balance sheet by allowing the legacy of quantitative easing to roll off at maturity. The program commenced in October 2017 and has put upward pressure on medium and longer-term yields. Meanwhile, the ECB's quantitative easing program will only stop at the end of December, and there are no plans to reduce their balance sheet. The bottom line is that the yield differentials all along the curve in the dollar versus the euro are highly supportive of a stronger dollar and weaker euro currency. Therefore, a break to the upside in the dollar index is long overdue based on monetary policy by the Fed and ECB.

A breakout to the upside could lead to volatility in the currency market

Whenever a market breaks to the up or downside the odds rise for a period of volatility as trend-following speculators and investors look to participate in a technical market event. Therefore, a break to the upside in the dollar index could lead to a period of increased volatility in the currency markets. Meanwhile, the dollar and euro are reserve currencies. One of their main attractions is their stability compared to other foreign exchange instruments. Governments tend to manage the currency markets to dampen volatility, so it is unlikely that we will witness a significant move to the upside in the dollar over a short period. Central banks could sell dollars to calm markets in the aftermath of a technical move to the upside that breaks above the mid-August high. However, the central banks and monetary authorities will not stop the move, just slow down its trajectory with their intervention in the currency arena.

So many issues facing the dollar index these days- UUP for those who do not trade in the forex market

As we head into the final months of 2018, many issues are hanging over the foreign exchange arena and markets across all asset classes. Rising interest rates in the U.S. has caused corrective price action in the stock market. The mid-term elections in the U.S. at the start of November could shift the power in the Congress from Republican to Democratic control which would likely impede the Trump Administration's legislative agenda. The political climate in the United States remains more divided these days than at any juncture in most of our lifetimes. Later this month, President Trump and President Xi will meet in Argentina, and the current trade dispute is likely to be first on the agenda. President Trump has already said that if there is no progress at the meeting, he is prepared to slap tariffs on all Chinese goods flowing into the United States. It is possible that the meeting in Argentina will result in a framework that leads to a deal on trade. At the same time, it is also possible that the trade dispute turns into a trade war following the summit. A trade war could increase inflationary pressures in the U.S., and it could also result in a slowdown in the global economy which would impact currency markets over the rest of this year.

Other issues are facing the world over the coming months. Sanctions on Iran that will take effect on November 4. Problematic relations between the U.S. and Russia continue to deteriorate after President Trump told the world he would walk away from a nuclear agreement with the Russians that had been in place since the 1980s because Russia has been cheating on the terms. The recent murder of a Washington Post journalist who was a Saudi citizen in Turkey has soured relations between the U.S. and Saudi Arabia which could impact the stability in the Middle East along with the sanctions on Iran. OPEC will meet later this month to decide on oil production policy. With the recent slide in the price of oil which has dropped by $10 per barrel over recent weeks, it is unlikely that the oil cartel will increase output quotas. Finally, the Fed looks set to raise rates at their December meeting and the central bank will outline their thoughts on monetary policy for 2019. While the market expects a rate hike of 25 basis points, the devil will be in the details and the plans for next year. Economic growth and concerns over inflationary pressures because of the trade dispute could cause a continuation of the hawkish approach to monetary policy which would provide support for the dollar to move higher over the coming weeks and months. Along with these many issues facing the U.S. and world on the economic and geopolitical fronts, there is always the unknown factors that tend to have the most significant impact on markets when they occur.

The stage seems set for the dollar to settle into a new a higher trading range. The next level of technical resistance on the dollar index stands at 97.70 and then at over the 100 psychological level on the index.

The Invesco DB U.S. Dollar Bullish ETF product (UUP) does an excellent job replicating the price action in the dollar index. The fund summary for the ETF states:

The investment seeks to establish long positions in ICE U.S. Dollar Index futures contracts with a view to tracking the changes, whether positive or negative, in the level of the Deutsche Bank Long USD Currency Portfolio Index - Excess Return over time, plus the excess, if any, of the sum of the fund's Treasury Income, Money Market Income and T-Bill ETF Income over the expenses of the fund. The fund invests in futures contracts in an attempt to track its index. The index is calculated to reflect the changes in market value over time, whether positive or negative, of long positions in DX Contracts.

The most recent top holdings of the ETF are:

Source: Yahoo Finance

UUP invests the majority of its net assets in dollar index futures contracts. The nearby dollar index futures contract has moved from lows of 87.20 in mid-February to its most recent level at 96.975 on October 30, a rise of 11.2%.

Source: Barchart

Over the same period, UUP has appreciated from a low of $23.09 to $25.88 on October 31, or 12.1% higher.

UUP is one tool that tracks the dollar index which looks as it is ready to move to a new level on the upside over the rest of 2018. The dollar took its time getting back to the highs, but now that it has arrived it looks like it may keep on going.

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This article was written by

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