The Dollar Index Breaks Down

Summary

• A move outside the recent trading range.
• The reasons for the decline of the dollar index.
• The US administration is fine with a lower dollar.
• Fiat currencies are all losing purchasing power.
• Back to the pivot point with UUP.
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On May 23, in a piece on Seeking Alpha, I wrote that the dollar index was “sleepy.” The index, dominated by an almost 58% exposure to the euro currency, had traded in a range from 98.815 to 101.03 from March 31 through May 26. I suggested that government intervention to provide stability to the foreign exchange market during the spread of the global pandemic was keeping the dollar index in a tight trading range.

From March 9 through March 23, the June dollar index futures contract exploded from 94.53 to its highest level since 2002 at 103.96, a 10% move in only two weeks. Currency markets rarely experience such extreme price volatility. Moreover, since the US dollar is the world’s leading reserve currency, stability in the greenback is in the best interest of all countries worldwide. After the period of the highest price variance in years, the dollar index settled into a narrow trading range, which was likely a coordinated strategy during the height of the pandemic. Last week, the index fell below the bottom of the trading range that had established the 100 level as a pivot point.

The Invesco DB US Dollar Index Bullish Fund (NYSEARCA:UUP) and its bearish counterpart (UDN) follow the index’s price higher and lower over time. The products are suitable for those wishing to take currency exposure without venturing into the futures or over-the-counter foreign exchange markets.

A move outside the recent trading range

After almost two months of trading in a narrow price band, the dollar index broke down last week.

Source: CQG

The daily chart of the June futures shows the decline to a low of 97.800 on June 1. Price momentum and relative strength indicators fell into oversold conditions as the index fell through the bottom end of its trading range. Daily historical volatility at 5.84% has been stable since late April after a spike to a high of over 21% in late March. The total number of open long and short positions in the index fell to 25,061 contracts on May 29. The open interest had been flatlining at around 32,000 contracts throughout May. A decline in price and falling open interest is typically not a technical validation of an emerging bearish trend in a futures market.

The reasons for the decline in the dollar index

Economic data in the US has reflected the self-induced coma created by the global pandemic. Applications for first-time unemployment benefits rose to over forty million. While many people will go back to work as the economy begins to reopen, companies will be doing a lot more with a lot less, meaning that a significant percentage of the unemployed will not have a job over the coming weeks and months.

First-quarter GDP data showed that the US economy contracted by around five percent. The second-quarter GDP data is likely to be a stunning reminder of the past three months as the contraction will be substantial, and perhaps record-breaking.

Last week, the dollar broke down after a slew of economic reports. Retail sales fell by a record 15.3% in March, which was far higher than the expected decline of 4.6%. At the same time, industrial production nosedived by over 15% in April. The consumer price and producer price indices have also moved lower. While the US economy is in recession, the data points to worse. Many analysts are warning that the numbers reflect an economic depression.

Aside from the impact of coronavirus, the US economy is facing increasing civil unrest. Police brutality in Minnesota sparked demonstrations, protests, and violence across the US over the past weekend. Warren Buffett once said that when the tide goes out, you find out who has been swimming naked. The racial and economic divide in the US comes when businesses are attempting to reopen, albeit slowly. A rise in civil disobedience could not have come at a worse time for the United States.

The US administration is fine with a decline in the dollar

The US economy moved into the global pandemic with moderate economic growth, optimism about the future, and the lowest level of unemployment since the 1960s. The landscape changed in what seems like a blink of an eye.

Since his election in November 2016, President Trump and his Treasury Secretary Steve Mnuchin, have consistently advocated for a weaker dollar. Past administrations had supported a strong dollar policy. The President and Secretary Mnuchin argued that a weaker greenback supports the earnings of US multinational corporations and American businesses as it makes US products more competitive in global markets. At the same time, as the administration renegotiates trade protocols with countries worldwide, a weaker dollar is a useful negotiating tool. Therefore, the recent breakdown in the value of the dollar is not likely to create any objections from the Trump administration. In March, when the dollar index exploded to almost the 104 level, the highest in nearly two decades, the Treasury was likely active in the foreign exchange markets to push the value of the dollar lower.

Fiat currencies are all losing purchasing power

The global foreign exchange market is a mirage as it measures the value of currencies against other foreign exchange instruments. The dollar index is a barometer of the value of the US currency against the euro and other foreign exchange reserve instruments.

Central banks hold dollars, euros, pounds, and many other currencies as part of their foreign exchange reserves. They also hold gold in the same category. The price action in the yellow precious metal continues to tell us that gold has gained value against all foreign exchange instruments over the past year. It has risen to an all-time high compared to euros, pounds, the Australian and Canadian dollars, the Chinese yuan, Russian ruble, and a host of other convertible and nonconvertible currencies. The latest shoe to drop was in the Swiss franc, which fell to a new record low against gold in May. In dollar terms, gold at the $1740 level is only around $180 below its record high from 2011. Gold has been moving higher against all foreign exchange instruments, which tells us that fiat currencies that depend on the faith and credit of the countries that print the legal tender are falling. The dollar and all other foreign exchange instruments are losing purchasing power.

Back to the pivot point with UUP

Currency pairs traditionally experience low levels of volatility as governments manage the foreign exchange market in the interest of price stability. It is unlikely that the central banks and Treasuries around the globe desire any significant price adjustments in the foreign exchange arena during the current crisis caused by coronavirus. Therefore, the dollar index is likely to fund a bottom above the March 2020 low of 94.53 on the June futures contract and head back toward the 100-pivot point.

The most direct route for a risk position in the dollar index is via the over-the-counter foreign exchange or the futures market on ICE. The Invesco DB US Dollar Index Bullish Fund (UUP) and its bearish counterpart (UDN) allow market participants to gain exposure to the dollar index in standard equity accounts. The fund summary for UUP states:

Source: Yahoo Finance

UDN has an inverse exposure to the dollar index. UUP has net assets of $1.01 billion, trades an average of over 2.1 million shares each day, and charges a 0.75% expense ratio. UDN’s net assets are $35.88 million, trades an average of over 54,000 shares each day, and charges the same 0.75% expense ratio.

The dollar index dropped from 100.605 on May 14 to a low of 97.800 on June 1 or 2.79%.

Source: Yahoo Finance

Over the same period, UDN rose from $19.60 to $20.15 per share or 2.81%. Both UDN and UUP do excellent jobs replicating the price action in the dollar index over time.

If the dollar is heading back to the 100-pivot point, the UUP product is a tool that allows investors and traders to participate in the foreign exchange market without venturing into the OTC for futures arenas.

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.

Comments

[EBrant]

Another great article, is this the time to buy 'inflation linked bonds' as a hedge against inflation over the next 5 years?
Andrew what are your thoughts on that?

Thanks
Ernest