Has the US Dollar Set a Significant Bottom?

2016-05-11 13:12:00

Talking Points:

- Traders constantly struggle with seeing the forest from the trees; attempting to see the bigger picture while also focusing on near-term price action. Today we look at the forest of USD price action.

- The US Dollar has been on a significant run of weakness up until last week, at which point a brisk turn-around began after the Australian Central Bank cut rates. But is this a lasting move, and further, what repercussions might such a change produce?

- If you’re looking for trading ideas, check out our Trading Guides. And if you want something more short-term in nature, check out our SSI indicator.

A major investment bank issued a bold forecast yesterday, calling for a bottom to have already been set in the US Dollar with the expectation for the currency to rise by 15% in the next two years as US rate policy normalizes. And while we usually avoid others’ forecasts out of respect and professional courtesy, this is a call that is certainly worth note given the context of what a stronger US Dollar would mean right now.

To provide some context, the US Dollar has been trending lower since setting a near-term high on January 29th. This was the day that the Bank of Japan made the surprise move to negative interest rates, and the initial response to that move appeared to be what the BoJ was looking for: Yen weakness. That yen weakness showed up in USD as that new high was set on the Greenback, but after markets re-opened on the following Monday, a markedly different tone had enveloped price action as February started off almost as rough for risk assets as January had.

The first week-and-a-half of February was particularly worrisome, as the semblance of a recovery that had been strung together in the second half of January came undone within the first week of February. And at the time there were multiple concerns: The Commodity meltdown had exposed numerous banks, Credit Default Swaps for many banks were shooting higher, China was looking like it had some tough times ahead, and US rate policy was indicating a full four hikes for 2016.

Created with Marketscope/Trading Station II; prepared by James Stanley

But the morning of February 11th was significant. This was the second day of Chair Janet Yellen’s twice-annual Humphrey Hawkins testimony in front of Congress. The first day of that testimony only seemed to hasten the themes of risk aversion as Ms. Yellen talked down the prospect of negative rates while continuing to talk up strength in the American economy. But a disconnect had already been shown as emerging markets had begun to put in some threatening moves. The second day of this testimony brought a far different tone from the head of the Fed, and this helped to produce reversals in key markets like Oil and global stocks.

Created with Marketscope/Trading Station II; prepared by James Stanley

The key take away from this testimony that appears to have helped form bottoms in these key markets was something that the world has gotten accustomed to: FOMC dovishness. As we had noted entering the New Year, the confluence of risk factors for the global economy would likely be too much for markets to bear, and this came to roost rather quickly. The one negotiable factor seemed to be US rate policy, and sure enough we’ve seen the Fed respond as equity markets began to flag signs of weakness.

And this has led to lower rate expectations out of the United States, which has led to a massive bout of weakness in USD. At the March meeting, FOMC reduced their median expectations for rate hikes for the remainder of the year to two from four and this only brought more weakness into the US Dollar while also bringing additional strength into commodities and equities.

Odds for a hike in June (the next FOMC meeting) are essentially priced-out of the market after last Friday’s abysmal NFP report; but perhaps more interesting is that with any new signs of weakness in the US economy, we’ve begun to see the US Dollar moving higher. And this is likely what led to that forecast calling for a bottom to have already been set in the Greenback. And perhaps there has been, but at this stage there is still scant evidence to suggest so.

Interestingly, while the US Dollar has been gaining over the past week, risk markets in Oil and Stocks have begun to show potential signs of topping. We discussed the technical setup in the S&P 500 yesterday, and the day before that we looked into Oil prices.

Should USD strength persist, both commodities and equities could become adversely affected, highlighting a continuation of the theme that markets had to contend with in January as a stronger US Dollar roiled both commodity and stock prices.

However, given the context of the situation with the numerous factors that could change at a moment’s notice, such as the fragility of the Chinese economic recovery, it seems more likely that we’ve simply seen a pause in the down-trend. At least at this point, that is what the technical structure in the Greenback suggests. We take a look at that recent structure below, and the Fibonacci retracement from the April 2015 high to the May 2015 low continues to provide usable levels on the chart, with the 27.2% extension of that move marking the top set on January 29th.

Yesterday produced a Doji at the 50% Fibonacci retracement, which was also a prior swing-high. This could offer short-side swing entries to traders looking for USD weakness to come back into the picture. But this type of theme could also be voiced with a long commodity or equity idea. For traders looking to trade a legitimate top-side reversal in the US Dollar, let this level of resistance first break to prove up-trend sustainability. Traders should be careful of chasing one week of strength after three-plus months of pain.