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3 Things Need to Happen for US Dollar to Cement Breakout

3 Things Need to Happen for US Dollar to Cement Breakout

Christopher Vecchio, CFA, Senior Strategist

Talking Points:

- USDOLLAR Index at TL resistance from January and February highs.

- Several factors need to cement themselves to secure a breakout.

- Higher volatility in FX markets should have implications for your trading strategies.

The USDOLLAR Index is holding just south of the trend resistance that has guided price lower since January. Several factors have played into the US Dollar's recent rebound, including a rebound in Q2'16 US GDP growth forecasts and rising Fed rate hike expectations. Likewise, the thinnest net-short positioning in EUR/USD in two years leaves fertile ground for dollar gains.

A few more factors are still needed to turn in the greenback's favor in order for USDOLLAR Index to secure a breakout, however. In the near-term, the top three are:

1) US economic data continuing to improve to underpin rising rate expectations. The recent improvement in consumption and inflation data out of the US, in context of the recent April FOMC minutes, has market participants rapidly scaling up the chances of a rate hike in June. Rising rate expectations via improving short-term rate differentials should help keep the US Dollar cushioned relative to other G7 currencies.

2) Other central banks need not panic as Fed officials talk up the possibility of a June rate hike. This week, better than expected GDP data from Japan has relieved calls for more immediate stimulus despite the stronger Japanese Yen this year. The BOJ is better off allowing other central banks like the Fed to do the heavy lifting right now - the more it continues to use its ammo with little effect, the more damage it does to its credibility.

Elsewhere, the PBOC last night strengthened both the onshore and offshore Chinese Yuan reference rates for the first time in three days - perhaps a vote of confidence in the market after the April FOMC minutes release. Chinese officials have recently expressed their confidence in the economy's "L-shaped" growth, playing down the likelihood of further stimulus this year. Further efforts to strengthen the Chinese Yuan reference rate against this backdrop would be further 'votes of confidence' in the economy by domestic officials and alleviate market concerns of a Fed-induced 'taper tantrum.'

3) USD/JPY needs to stay elevated. If the market pushes up USD/JPY without the impetus of a BOJ intervention around the corner, the chances of it being a lasting move are more likely. But there's a risk component here as well. If a broad US Dollar rally provokes a fall in US equity markets, the Japanese Yen will likely gain favor reflexively. This is a direct threat to the rising possibility of a June rate hike, which would remove the most potent source of US Dollar strength over the past few weeks.

Breaking the fourth wall here, everyone knows the Fed's third mandate is to keep asset prices elevated. If USD/JPY is unable to sustain its gains, then it probably means that equity markets around the world are taking a hit - and as we've seen in the past, weaker US equity prices have proved to be a strong deterrent to the Fed hiking rates.

See the above video for technical considerations in EUR/USD, USD/JPY, the USDOLLAR Index, Gold (CFD: XAUUSD), and Crude Oil (CFD: USOIL).

Read more: Rising Fed Rate Expectations Cushion US Dollar - What About Risk?

If you haven't yet, read the Q2'16 Euro Forecast, "EUR/USD Stuck in No-Man’s Land Headed into Q2’16; Don’t Discount ’Brexit’," as well as the rest of all of DailyFX's Q2'16 quarterly forecasts.

--- Written by Christopher Vecchio, Currency Strategist

To contact Christopher Vecchio, e-mail cvecchio@dailyfx.com

Follow him on Twitter at @CVecchioFX

To be added to Christopher's e-mail distribution list, please fill out this form

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

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