The Dollar May Be Down But Is It Out?

So far in 2018 we have tried to be fairly flexible with our thinking on the US Dollar. Fundamentally, we could quite easily build a bullish case as much as we could build a bearish case. Indeed, there will almost certainly be periods this year when the Dollar seems to be in freefall and periods when the market is scrambling to buy. In the last week or so, sentiment has turned decidedly bearish of the Dollar. This would obviously be proved right if the Dollar collapses from here, but the markets have a nasty habit of catching the most people off guard at the wrong time, and simply put, we are not sure that an immediate collapse is inevitable.

As measured by the popular Dollar index (DXY), the Dollar fell by nearly 10% last year, and by another 1.7% so far in 2018. As indicated in chart 1 below, price has quickly come down to test a downward sloping trend line created since 2015. Will the Dollar simply collapse though this potential support, or will it try and mount some sort of defence here?

Chart 1 – Weekly chart of US Dollar Index

The biggest driver of FX at the moment is the combination of the US slowly but surely losing its reserve currency status and large reserve managers selling Dollars to both reflect this long term dynamic and to perhaps diversify to a changing global economic and political reality, as influenced by China in particular (the One Belt One Road initiative is an obvious factor). Reserve managers are the 800lb gorilla in the market. When they start shifting money around, it can create extremely powerful trends, and we have no doubt that this helps explain the 10%+ slide in the Dollar last year.

So, the immediately bearish case for the Dollar is most likely predicated on reserve managers continuing to sell the Dollar. The trouble is that they don’t announce what they are about to do, only what they have done (several large central banks have recently announced shifts in their reserves away from the Dollar and into the Chinese Yuan). A solid close below the red trend line in chart 1 probably confirms the big picture bearish case. However, if the Dollar is going to mount any sort of challenge, even one that may only last a week or two, it has to start right here.

What we find somewhat intriguing at this juncture is that although the Dollar Index (DXY) has broken below the low created in September, the Bloomberg Dollar Index and the Broad Dollar Trade Weighted Index (neither shown) have so far just about held at that previous low. Amongst developed currencies, the Euro and Sterling are trading above their respective September highs, but no other currency is. In fact, the strongest currency bloc is the mercantile Asian group including China. We wonder whether this more disparate performance of currencies against the Dollar (and especially amongst developed currencies) is in fact a subtle sign that the Dollar is not yet ready to collapse.

When we look at other inputs such as interest rate differentials and market positioning, we again think that there is room for the Dollar to rally, if only reserve managers give it a break and some sort of good news event for the US happens.

We enter the world of interest rate differentials somewhat gingerly here, as these have simply not mattered in the FX markets for months now, especially when comparing the Dollar to currencies in Europe. But let’s take a look anyway.

Chart 2 shows the EUR/USD exchange rate (Green line) and the difference between 5 year US and German Government bonds (white line). Up until July last year, relative movements in bond yields clearly had an influence on the exchange rate, and then something changed. Opinion seems to be divided as to what exactly changed. Yes, the European economy seems to be on a firmer footing, and the political heat may well be subsiding. The result may well be a faster than previously estimated exit from the extraordinary policies pursued by the ECB. Our view is that Dollar selling by reserve managers probably started in earnest last summer.

The question is whether investors suddenly look at rate differentials and shift their view on the Dollar or will other factors continue to render this input ineffective for longer? Only time will tell.

Chart 2 – EUR/USD exchange rate and 5 year yield differential

Humans are herding animals by instinct, and more often than not, when the bullish or bearish camp becomes too crowded, the market is about to turn. When we look at the Commitment of Traders data for the Euro (chart 3 below), we see that speculative accounts hold a record net long position, and that they have quite aggressively added to these long positions in the last few weeks. We suspect that if the Euro begins to turn lower here, these latecomers will begin to get a little concerned, and a move below 1.20 and especially 1.19 would put most of the recent purchases under water.

Chart 3 – EUR/USD exchange rate and speculative positions held

If we drill down to a shorter time frame, what we see on the EUR/USD exchange rate in January is quite interesting. In the first few days of the year, price traded up to the previous highs seen last September, and hesitated for four trading days before creating a small pullback. Next we saw a strong break out above the previous resistance. In the last four days, we have what appears to be yet another pause, or perhaps a short term top.

So long as the Euro trades above the previous breakout level (about 1.2070) then we have to say that the Euro remains in a bullish trend. If the Dollar can gain some support, and the Euro begins to falter, we would need to see that support level broken, and then the January pullback low just above 1.1900 would need to be broken. As noted above, a move back below 1.20 (and especially 1.19) would put many recent bullish Euro trades under water, and if they then choose to cut and run, some selling momentum could begin; and with Euro longs at a record high, any selling momentum could gather a force that may surprise many. Furthermore, a move back below the 1.20 area would indicate that the January surge higher in the Euro was actually a false breakout, and would leave the potential for a move down to the 1.16 area seen in early November.

Chart 4 – Daily EUR/USD exchange rate

We don’t have time to present charts on all currency pairs here, but we would like to show one more. As noted above, Sterling is the only other G10 currency this year to trade above its high from last September. Chart 5 below shows the daily chart for Sterling versus the Dollar and we have incorporated a simple trading envelope on the chart.

These trading envelopes are supposed to help guide when to buy and sell as the vast majority of price action is contained within the boundaries. However, price can move outside the boundaries of the envelope, as it did last September. To protect against blindly selling at the top of the envelope, the theory goes that after price closes outside the envelope, you should wait for price to close back inside the envelope before selling. Otherwise, you should look to buy near the bottom of the envelope and sell near the top. We would also note that this techniques works better in markets that are not in strong trends.

Chart 5 – Daily chart of GBP/USD with trading envelope

Currently, Sterling has been trading to the upper boundary of the envelope in recent days but has failed to close outside it. Furthermore, twice last week, Sterling traded to the 1.3945 level and then pulled back a tiny bit. It’s a little too early to tell, but Sterling may be due for a short term correction. We have not marked this on the chart, but the 1.36 area was previous resistance which may act as support if Sterling decides to correct a bit from here.

From a fundamental news perspective, next week could be important, as the European Central Bank meets on Thursday. Although there appears to be a growing shift on the Council to be more explicit about their view that the economy may well now be on a sustained growth path and that they need to communicate their exit plan, we think that Draghi remains firmly in the “dovish” camp, for now at least. We think that he will try and deflect any questions on exit plans by confirming current policy, i.e. he will simply state that QE will continue at EUR30 billion per month until September and that rates will remain low until well after the end of QE, and ignore all questions on policy shifts and the timing thereof.

Simply put, if the market thinks that Draghi is too dovish, there is the potential for the Euro to be sold in the market. This would likely drag other currencies down against the Dollar too. If at the same time, there is some news seen as Dollar positive, then there really could be a strong potential for a near term Dollar rally.

So to try and wrap things up this week. The Dollar has been sold quite aggressively in recent weeks, and is now down nearly 13% in the last 12 months as measured by the DXY Dollar Index. Sentiment, that was almost universally bullish on the Dollar post the Trump victory a year ago, now seems to be almost universally bearish. This is supported by a record long position held by speculative accounts on the Euro, as well quite large positions held in most other currencies (the Japanese yen being the major exception and to a lesser degree the New Zealand Dollar).

We cannot predict what reserve managers may do in the next few weeks or months, but what we can say is that positioning and sentiment have moved so far against the Dollar that we would not be surprised if the Dollar enjoyed some sort of rally, even if only for a week or two. If we are right on this, then we will be on the lookout for a larger rally that may help the Dollar back to 95 area seen on the Dollar index last October/November time; this would represent nearly a 5% rally.

Essentially, we think the next week or so is important for the Dollar. We certainly recognise that reserve managers can have a significant impact on markets, and if they chose to keep selling the Dollar, then the current Dollar bear move could extend quite a long way. However, some ingredients for a Dollar rally are apparent.

If the Dollar can do no more than pause in the next week around current levels, then we suspect that what is happening is that the Dollar is simply pausing before renewed selling comes in. However, if the Dollar begins to rally, and let’s say that the ECB is dovish and then there is actually a good news event for the Dollar, there is an awful lot of short Dollar positions that need to be bought back.

What does this mean in terms of trading views (not necessarily big long term views)? We think that at a minimum, those who are short Dollars should be cutting back or going flat/neutral. For those that want a stab at being long Dollars, we would do so with both a price and time limit. If the Dollar is going to rally, it has to do so now. If the Dollar either starts to trade below last week’s lows (and Euro and Sterling above last week’s highs) then we are wrong. Furthermore, if the Dollar just languishes around current levels for the next week or so, we are probably wrong. Either way, the reward/risk ratio looks quite reasonable here to be long US Dollars for a trade with quite a tight stop.


Stewart Richardson
RMG Wealth Management

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