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Why Can’t the Dollar Hold its Gains? Here are Two Factors

By , Quantitative Strategist
23 August 2013 21:00 GMT

The US Dollar rallied sharply after holding key lows through this week’s trading, but today has the Greenback falling sharply versus the Euro, Swiss Franc, and Australian Dollar. What is getting in the way of a more sustained Dollar bounce? We’re looking at two factors in particular—forex volatility and positioning.

Lack of Volatility Getting in the Way of Dollar Strength

The chart below shows that the Dow Jones FXCM Dollar Index (ticker: USDOLLAR) broke above a major falling trendline through late 2009 as forex volatility likewise moved significantly higher.

Despite the most recent move higher, however, volatility prices have been unable to break a very similar trendline.

DailyFX 1-Month Volatility IndexCritical to GuidingDow Jones FXCM Dollar IndexMoves

forex_analysis_-_why_cant_the_dollar_hold_gains_body_Picture_5.png, Why Can’t the Dollar Hold its Gains? Here are Two Factors

Data source: Bloomberg, DailyFX Calculations, Chart Source: R

A strong correlation between the USDOLLAR and volatility suggests the next big Dollar rally will need to come on a bigger breakout in forex market volatility. There’s another key factor keeping us from calling for a much larger USD rally, and it’s the fact that too many people are making the same trade.

Too Many Traders Calling for the Same Trade – Forex Positioning Needs to Shift

Yesterday we highlighted the fact that there was risk of a major EURUSD reversal and broader Dollar recovery, but that was contingent on a similarly significant pullback in forex trader positions. What does that mean exactly?

Our FXCM Speculative Sentiment Index data uses real trader data to tell us how many people are long or short a specific currency pair, and this information drives our sentiment-based trading strategies. It’s usually pretty simple: if everyone’s buying, we typically look to sell; if everyone’s selling, we typically look to buy.

Yet the trading crowd was recently its most short EURUSD on record—a clear sign of a potential sentiment and price extreme. It’s at these major turning points that we might actually look to trade in the same direction. Or in other words, when traders are extremely short we might look to sell as well.

Retail Forex Traders were Most Short EURUSD on Record, Remain Heavily Net Short

forex_analysis_-_why_cant_the_dollar_hold_gains_body_Picture_6.png, Why Can’t the Dollar Hold its Gains? Here are Two Factors

Source: FXCM Execution Desk Data

There’s a clear caveat in calling for THE extreme in SSI and price, however; tops/bottoms are only clear in hindsight and we need concrete signs of reversal. To confirm a EURUSD turnaround we would like to see the crowd do the opposite as the pair pulls back and buy into weakness.

That fact is preventing our SSI-based Momentum2/”Tidal Shift” from taking a short position, and indeed we listed this as a potential confirmation signal that the EURUSD did in fact set an important peak at $1.3450. We’ll need to see a turn in retail positioning before getting aggressively bullish USD.

Wrapping Things Up: Can the Dollar Recover More Consistently?

The fact that the Dollar has failed to follow-through on gains is enough reason to make us question the potential for a bigger bounce. But we’ll be watching both forex volatility and positioning to further confirm the potential for THE US Dollar reversal.

Receive future special reports on forex volatility and US Dollar positioning via my e-mail distribution list with this link.

Forex Correlations SummaryView forex correlations to the S&P 500, S&P Volatility Index (VIX), Crude Oil Futures prices, US 2-Year Treasury Yields, and Spot Gold prices.

forex_analysis_-_why_cant_the_dollar_hold_gains_body_Picture_7.png, Why Can’t the Dollar Hold its Gains? Here are Two Factors

Data source: Bloomberg. Chart source: R

SEE GUIDE ON READING THE ABOVE CHART

--- Written by David Rodriguez, Quantitative Strategist for DailyFX.com

David specializes in automated trading strategies. Find out more about our automated sentiment-based strategies on DailyFX PLUS.

Contact and follow David via Twitter: https://twitter.com/DRodriguezFX

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23 August 2013 21:00 GMT