A Small Note of Caution on Our Bullish Dollar Thesis

Last week, we laid out clearly our thoughts on the potential for a Dollar rally; and it’s nice to get something right, as the Dollar either broke out or extended gains against all major and emerging currencies. To be clear, we do expect further gains in the weeks ahead, but we are a little wary of pushing the trade idea too far in the here and now as nothing moves in a straight line forever (corrections are to be expected, even in the best of trends), and US yields are still unable to really break out.

Starting with the Dollar index. The positive way to interpret the current set up is indicated in chart 1 below. Price has broken out of a well-defined basing pattern, and in the process has broken above a key downtrend that has been in place for 16 months, and price is now above key medium term moving averages. Our bullish interpretation suggests that the Dollar is in the early stages of at least a multi week rally.

Chart 1 – Daily Dollar Index with 50 and 100 day moving averages

However, we have to remain alert to a bearish alternative, as depicted in chart 2 below. Price has risen to the top of a channel that may prove to be just a corrective channel in a larger Dollar bear market. The coincidence of this channel test and the test of the still falling 200 day moving average, and a late day sell off on Friday means that we cannot dismiss this bearish alternative.

Chart 2 – Daily Dollar Index with 200 day moving average

So, how do we overcome the disparity between these two alternatives? Well, we can have a look at some of the factors that drive currencies, but even here, the evidence is a little ambiguous. For example, interest rate differentials have given close to zero steer in recent months. As can be seen in chart 3, the EUR/USD exchange rate moved mostly together with US and German yield differentials up to last Summer. Then, the correlation began to weaken before disintegrating in recent months.

Chart 3 – EUR/USD exchange rate with 5 year US/German yield differential

That said, it shouldn’t hurt the Dollar too much if US yields are rising (or at least rising faster than German yields). So, the Dollar bulls will definitely be looking for US yields to keep rising, which they have in recent weeks. The Dollar bears will point out that even if rates are a key driver of currency returns, perhaps the US 10 year yield is just not ready yet to break above the next key resistance at 3.05%.

Supporting the higher yield environment is the fact that the Fed will continue to raise interest rates (assuming the equity market doesn’t collapse) and inflation is definitely headed higher. Supporting the potential downside in yields is the theory that these two factors are now so well known and are in fact discounted by the market. Indeed, speculators are holding a record short position in 10 year bond futures (data not shown), and if price starts to rise (yields fall), they may be encouraged to buy back their short positions, potentially pushing yields down quite a bit in the weeks ahead.

Chart 4 – Monthly US 10 year generic bond yield

We continue to believe that factors like FX Reserve management has been influencing exchange rates more heavily in recent months. Basically, global reserve managers have decided to reduce their exposure to the Dollar which has helped the Dollar weaken in the last 16 months despite what appeared to be Dollar supportive interest rate movements. Unfortunately, we are not privy to what these guys will do next, but if they choose to relax their diversification (away from the Dollar) efforts, and US corporates decide to repatriate their stash of overseas profits back home, there is every chance the Dollar will rally in the weeks or months ahead.

We also know that nobody likes a strong currency (especially in Europe and Japan), and perhaps it will be decided by the powers that be that after a 16 months period of Dollar weakness, it is time for others to “benefit” from some currency weakness.

All of this current ambiguity just goes to show that it really is not easy to predict anything. For what it’s worth, we are sticking with our view that the balance of probabilities lie with a stronger Dollar outlook for a period of time. Having seemingly broken out of well defined basing patterns last week, we should not be at all surprised to see a period of consolidation before further gains are seen. This would be a very usual occurrence in the early days both after a breakout and in the early stages of a new trend. We think that any such consolidation period should last only a few days; two weeks at the most. So, we need to be patient here for the market to tip its hand, but hopefully we won’t have to wait too long.

As with last week, we not only focus on the Dollar because we sense a profit making opportunity. We also focus on the Dollar because it is still THE global reserve currency, and so is still THE important benchmark. A too strong Dollar will generally be bad for risk assets, perhaps Emerging Market assets especially. A gently weaker Dollar would be good news. Not for the first time in recent months, we sense markets are at an important juncture.

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