USD: what to expect next?

Summary:

• Donald Trump puts a ceiling on the latest US dollar rally
• German yields look more attractive compared to US yields if currency risk is taken into account, the spread has stopped falling
• CFTC signals the greenback net positioning has switched to positive of late, at the same time the dollar looks overvalued from the long-term point of view
• Technical analysis points to a risk factor as for selling the buck right now

The US dollar index gained almost 7% since mid-April to the end of May when the price struck a 95 handle which has become a glass ceiling since then. The price has been trying to break it out many times, but it has failed to do so as of yet. The latest remarks from Donald Trump regarding the exchange rate make this breakout more unlikely. In today’s analysis we focus on the US dollar index (USDIDX on xStation5) in search for a possible reversal.

Donald Trump drew attention on Friday’s afternoon when he decided to talk the greenback down tweeting that the stronger currency puts the US economy at a disadvantage. He accused foreign central banks, especially the ECB and the PBoC, of manipulating their currencies and interest rates ripping the US of a competitive advantage. Even as it was not the first time the US President chose to weigh in, this time was a bit different. Notice that earlier last week Trump expressed his discomfort with the current course of the Federal Reserve monetary policy disagreeing that the economy needs higher rates. Looking back to the past one may identify two major points when Donald Trump referred to the exchange rate. First, at the end of 2016 he said that the greenback was too strong (the USD index was slightly above 100). Subsequently, at the beginning of this year, when the index slipped below 90 he suggested the US currency would be stronger and stronger. Trying to infer something valuable one needs to underline that each time when Trump involved in the currency thread the dollar went toward his desired direction (with some lag). Is the history going to repeat itself this time around as well?

Germany-US FX hedge-adjusted spread has stopped declining lately, the EURUSD has halted its falls as well. Source: Bloomberg, XTB Research

Politicians have often their preferences regarding the exchange rate but for currencies on the developed markets bond yields are among the key indicators behind short term fluctuations. In general, when it comes to developed markets the higher yield, the higher demand for the currency. However, a currency risk is built in bond investments therefore this factor needs to be taken into account when trying to forecast currency movements. The chart above depicts German and US 10Y yields from a Japanese investor point of view. As one can notice, despite a remarkable difference in nominal rates in favour of the US, when FX hedge costs are taken into calculations it turns out that the German 10Y yield looks more attractive than the US 10Y yield for an investor residing in Japan. Notice that the correlation coefficient between this spread and the EURUSD equals approximately 72% and it is statistically significant (for the daily data spanning from May 2017 till today). The pivotal aspect one needs to pay attention to is the fact that the flatter US yield curve, the less net gain a potential Japanese investor can make purchasing treasuries. Let us recall that the US 2y10y nominal yields spread slipped below 25 basis points last week for the first time since August 2007.

USD net positioning has increased notably implying more space for fresh shorts. Source: Bloomberg, XTB Research

Possible darker clouds swirling over the US dollar coincide with the recent shift in the speculative positioning reported by the CFTC each Friday. Notice that after several months with the net short position the change occurred and currently we are well above the neutral level. Given that Donald Trump is unlikely to accept the stronger dollar one may suppose that some speculators may bet against the buck over the coming weeks. Once it happens, it could result in a switch to the net short position anew. Analysing the CFTC data one cannot omit the fact that such currencies as AUD, NZD, CAD or CHF are among most oversold currencies increasing the probability that FX investors could switch from USD longs to shorts assessing that the greenback could struggle to gain much more given strong Trump’s reluctance.

Taking a look at the USD TWI one may spot that it again hovers close to its record highs. Source: Macrobond, XTB Research

Last but not least, approaching currencies from a long-term standpoint it’s worth knowing where we actually are, and TWI indices seem to be the best suited to measure the currency over- or undervaluation. The chart above also presents the number of standard deviations from the 20-year average (the green line) indicating the dollar is trading between 2 and 1.5 standard deviations. Putting it simply, from the long-term backdrop the US dollar is placed among the most overvalued currencies in the G10 basket.

What are risks related to selling the US dollar? The most obvious one is the fact that the greenback is perceived by market participants as a ‘safe haven’. Therefore, when a turmoil in financial markets arises, it usually tends to lead to the stronger dollar as investors close their non-dollar positions and converse their cash into US dollars. In turn, in this particular example we might identify yet another risk factor - stemming directly from technical analysis. Namely, looking at the daily time frame of the US dollar index one may discern the forming triangle pattern which is classified as a continuation pattern. Buyers have been trying to move through a 95 handle already several times, but they have failed to do it thus far. Nonetheless, it seems to be too early to say that they have already thrown in the towel altogether. Keep in mind that the longer period of time a resistance cannot be broken, the higher probability to see a more meaningful breakout. Either way, we reckon that even if this level is broken, bulls might find it hard to continue their rally given the latest Trump’s comments.

The daily chart illustrates that bulls keep struggling with their major obstacle localized at 95. Source: xStation5

Having a look at the daily chart of the US dollar index (USDIDX) one may notice the ascending triangle pattern which is slowly coming to an end. Nonetheless, it may still take some time before the price leaves this formation altogether (even up to mid-August). Having in mind that the price has come back toward the 95 level several times one can consider entering a short limit order at this level with a stop loss placed at 96.1 as well as two targets at 92.5 and then 91.5. Based on the daily chart it seems that even as the price breaks above 95, it could be stopped by another resistance of 96 being underpinned by a 50% retracement of the plunge from the end of 2016 to January/February this year.