The Dollar Waits For News From Europe And The Fed

Summary

• A new high and a rest.
• Brexit could move the dollar on December 11.
• The Fed will send a signal to the currency market on December 19.
• U.S. domestic politics could provide surprises that would impact the greenback.
• UUP does an excellent job tracking the dollar index.
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We have seen wild action in many markets over recent days and weeks. The price of crude oil dropped from a high of $76.90 per barrel on the nearby NYMEX futures contract on October 3 to under $50 at the end of November. The stock market that experienced increased price variance during the typically volatile month of October has continued to swing higher and lower throughout November and into December. Markets reflect the economic and political landscape around the world, and these days there is no shortage of issues that are keeping traders and investors on their toes.

The international currency markets tend to be the least volatile asset class because central banks, monetary authorities, governments, and supranational institutions tend to manage the foreign exchange market in the interest of stability. Stable currencies are imperative when it comes to international trade and managing global and domestic economies. The dollar and the euro are the reserve currencies of the world which means that most central banks around the globe hold the legal tender as reserves. It also means that it is in the best interest of all nations that the dollar and euro experience as little volatility as possible. While they change value against each other and other foreign exchange instruments over time, a slow rate of change is always preferable as it allows business and the official sector to adjust to trends.

The euro currency makes up 57% of the U.S. dollar index. Therefore, it tends to reflect changes in the dollar-euro exchange relationship. The index hit a low at 88.15 in February 2018, and since then it has been trending higher making higher lows and higher highs in a slow and steady rally. In mid-November, the dollar index rose to its latest peak at 97.53 in the December futures contract. The Invesco DB US Dollar Bullish ETF product (NYSEARCA:UUP) does an excellent job tracking the dollar index for those who do not venture into the futures market or the OTC foreign exchange arena.

A new high and a rest

After making its most recent high at 97.53 on November 12, the dollar index has been trading quietly above 95.93.

Source: CQG

As the weekly chart highlights, the trend in the dollar index continues to be higher, and the greenback is following a pattern of resting after a new high. Before mid-November, the peak in the index came in mid-August at 96.865 and after a period of a correction down to a low at 93.395 in mid-September, the U.S. currency began to climb. The dollar index eventually made it to a higher high that was just 0.665 above the level in August.

The dollar index futures contract closed at around the 96.500 level last Friday, and weekly historical volatility has dropped to 3.35%, the lowest level in 2018 and many years. The dollar has gone to sleep and is waiting for news which could come this week.

Brexit could move the dollar on December 11

Last week, the U.K. Parliament voted to hold the government of Prime Minister Theresa May in contempt after she refused to release legal counsel’s reports surrounding the Brexit plan that the E.U. has already approved. At the same time, the Parliament voted that if her plan fails to gain majority support, the legislature will take control of the divorce process.

It is getting late in the game for Brexit as the final deadline comes on March 29, 2019. On Tuesday, December 11 the Parliament will vote on the plan. If it passes, we are likely to see a rally in the pound against both the euro and the dollar. However, the price action in the U.K. currency has been bearish with the pound dropping to a new low for 2018 last week.

Source: CQG

As the chart illustrates, the pound-dollar relationship fell to $1.2665 last week after the Parliament handed Prime Minister May defeats on Tuesday. While the currency recovered to just over the $1.2750 level on Friday, we could be in for a wild week in the currency market. Finalization of the divorce would be bullish for the pound, but a no vote on May’s plan could spell the end of her role as the leader of the nation. Moreover, a rejection of the plan that she already negotiated with the E.U. and they approved would inject lots of fear and uncertainty into markets far beyond the U.K. and could cause a wave of contagion the likes of which we have not seen since the night of the Brexit referendum.

European officials have been saying that the current plan is a take it or leave it deal. Additionally, to put additional pressure on Members of Parliament, attorneys for the E.U. noted that the U.K. would be within its rights to decide to retract their exit from the union. However, remaining within the E.U would hand a repudiation to the majority of citizens who voted in favor of the divorce. Brexit is a complicated political, and economic issue and the December 11 vote in Parliament is likely to inject lots of volatility into the foreign exchange market this week.

The Fed will send a signal to the currency market on December 19

Once Brexit is out of the way, or anarchy breaks out across the Atlantic Ocean, the Fed will meet next week in its final gathering of 2018. The members of the FOMC will decide if the Fed Funds rate will rise by 25 basis points on December 19 and will provide guidance on monetary policy for 2019.

The Fed has prepared the market for the fourth rate hike of 2018, but recent market volatility could make them pause, so the result is not a one-hundred percent certainty when it comes to a rate hike this month. Meanwhile, now that Chairman Powell and other members of the Fed have told markets that short-term rates are close to neutral, it is likely that the statement and press conference that follows the December Fed meeting will be less hawkish than past meetings.

Whatever the Fed decides, the legacy of years of quantitative easing continues to roll off the central bank’s swollen balance sheet which has been putting pressure on medium and longer-term rates. The differential between short, medium, and long-term rates in the U.S. and those in Europe have been widening throughout 2018 which has provided support for the dollar against the euro currency and is the reason why the dollar index is not far off its high for this year and the highest level since June 2017. A continuation of a widening of the differential will support gains in the dollar in a perfect world, but the world is anything but perfect these days. On Friday, a Fed official warned that a rate hike may not be necessary at the December meeting. Employment data came in at 155,000 new jobs which was slightly below market expectations. Wage growth also continue to lag in the employment sector as the unemployment rate is at 3.7% in the United States. The recent action in markets has created more uncertainty about the fourth rate hike of the year at the December 18-19 FOMC meeting.

U.S. domestic politics could provide surprises that would impact the greenback

There are lots of irons in the political fire in the United States, and around the world, that could cause shocks to the markets, and currency values are no exception. On the international front, the trade issue with China will come to a head early in 2019 as the deadline for the extension for any new protectionist measures by the U.S. or China approaches. In the U.K. a no vote on the Brexit plan could lead to a new Prime Minister for the nation and lots of uncertainty as the end of March deadline for Brexit approaches. The Middle East continues to be a focal point for problems in the world. While President Trump has supported Saudi Arabia as evidence of the Crown Prince’s involvement in the murder of a Washington Post journalist and Saudi nation has mounted, other leaders in the U.S, have been calling for a harsh response and penalty for the actions of MbS in October 2018. Moreover, the U.S. continues to posture with the Russians in the region for influence while Russian aggression in Ukraine could become a flashpoint. Those are just a few of the many geopolitical issues that could cause uncertainty in volatility in markets early in 2019.

On the domestic front, New Year’s Day will mark a shift in political power from the Republicans to the Democrats in the House of Representatives. While gridlock in government has been favorable for markets in the past, we are facing a very different and divided political landscape in the U.S. these days. It is possible that the special prosecutor is preparing to hand the Trump Administration a fistful of problems and perhaps indictments. The recent recommendation for a light sentence for General Flynn who pled guilty to charges of misleading investigators is a sign of cooperation which could lead to problems for other administration officials and even members of the President’s inner circle and family. The President’s son, Donald Trump Jr. recently told friends that he expects to be indicted by the Mueller investigation.

With the Democrats in charge of the House and the potential for criminal prosecutions of those close to the President of the United States, the prospects for impeachment proceedings will increase next year. With Republicans firmly in control of the Senate, the chances of a conviction after impeachment are low, unless of course, the Mueller investigation yields charges that members of the President’s political party cannot ignore. At the same time, the 2020 Presidential election will kick into high gear early in 2019 with candidates announcing their intention to run for the highest office. While the 2016 election was highly contentious, 2020 could be even worse when it comes to political division.

Currency markets reflect economic and political events, and 2019 is shaping up to be a year of even more uncertainty than 2018 which means that we need to fasten our seatbelts for a continuation of market volatility in the dollar and across all asset classes.

UUP does an excellent job tracking the dollar index

The dollar index has been in a bull market since reaching a low at 88.15 in February. Interest rate differentials between the dollar and the euro continue to favor the U.S. currency, but the many issues on the horizon could derail the path of the greenback next year. All of the evidence currently points to lots of price variance in markets across all asset classes. Since February, buying dips in the dollar and taking profits at new highs has been the optimal strategy.

For those who do not trade dollar index futures or in the OTC currency market, the Invesco DB US Dollar Bullish ETF product (UUP) provides an alternative. The fund summary for UUP 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 UUP include:

Source: Yahoo Finance

UUP holds dollar index futures contract. With net assets of $535.13 million and an average of 830,961 shares changing hands each day, UUP is a highly liquid tool for those who wish to take a long position in the U.S. dollar. During the week of February 12, the dollar index hit its low for the year at 88.15 and rose to 97.53 in mid-November, a rise of 10.64% over the period.

Source: Barchart

Over the same period, UUP rose from $23.12 to $26.02, a gain of 12.54%. The outperformance of the UUP product was the result of the higher yield in the dollar compared to other currencies over the period. UUP charges an expense ratio of 0.76%.

The dollar index is waiting for news from Brexit, the Fed, and a host of other issues over the coming days, weeks, and months. Since February, buying the dollar index or UUP on dips and taking profits at new highs has been a profitable strategy. While past performance is never a guaranty of the future, a trend can be a trader or investors best friend, and currency markets tend to trend for extended periods.

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.