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US Dollar Bounces From Three-Year Lows; Is the Pain Trade Over?

US Dollar Bounces From Three-Year Lows; Is the Pain Trade Over?

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Talking Points:

- The Dollar put in an aggressively bearish move throughout this week, seeing a fresh three-year low print in the overnight session. Since then, a rather short-term rally has started from those lows, and traders should move-forward very carefully. Monday is a banking holiday in the United States in observance of President’s Day, and this would be a Friday-retracement after an outsized move-lower ahead of an extended weekend. Be careful with short-term positions, making sure that they don’t turn into longer-term problems.

- The big question is ‘why’? With US rates rising as inflation continues to show, the USD-fall has many scratching their heads. But – there may be a very requisite reason for a divorce of fundamentals, and that rationale would be driven by positioning across bond markets as global central banks move further away from quantitative easing. This move of USD-weakness, while stretched, may still have the context with which to continue for a while longer, even if we do see a retracement of a portion of recent losses.

- Are you looking to improve your trading approach? Check out Traits of Successful Traders. And if you’re looking for an introductory primer to the Forex market, check out our New to FX Guide.

If you’re looking for longer-term analysis on US Stocks, the Euro or the U.S. Dollar, click here for our Trading Guides.

US Dollar Crushed After Strong Inflationary Read

It was a big week for the US Dollar. As we opened trading on Monday morning, the Greenback was holding on to last week’s gains, finding a bit of support above the 90.00 level on DXY. Given that this strength was showing after what’s been an impressive year of losses made that observation all the more interesting, as it could’ve been leading to a longer-term move of USD strength that might last for a couple of weeks or perhaps even a few months. This was similar to what was seen last September, when an enhanced bout of selling in June and July finally ran into an area of support that brought two months of gains to the Greenback. Of course, that weakness came back in December and really hastened throughout January, bringing a slight change-of-pace in February as the Dollar started to show a bit of strength.

US Dollar via ‘DXY’: February Strength Erased, Now Bouncing From Fresh Three-Year Lows

us dollar daily chart

Chart prepared by James Stanley

Buy the News – Sell the Reaction

The US Inflation report on the calendar for Wednesday morning was the object of focus, as recent market dynamics have appeared to indicate a sensitivity to inflationary pressure in the US. The jump in Average Hourly Earnings in the Non-Farm Payrolls report earlier in February appeared to really drive the risk aversion throughout global markets, and with another key piece of inflation data on the docket, markets were looking for clues as to just how strong inflationary pressures are showing in the US economy.

This number came out at 2.1% versus the expectation of 1.9%, marking the fifth consecutive month of CPI-growth that’s at-or-above the Fed’s target of 2%. Normally, a read of this nature would bring strength to a currency on the basis that higher inflation means a stronger probability of higher rates, leading to flows into the currency to capture those new, higher rates. And for a few minutes on Wednesday morning – this happened; but it didn’t last for long, and sellers came back with a vengeance after DXY posed a quick re-test of that 90.00 level. Bears have remained in-control for most of the time since, leading to a fresh three-year low set in the overnight session.

US Dollar via ‘DXY’: Quick Pop of USD-Strength After CPI (in Blue); Aggressively Faded

us dollar via dxy hourly chart around cpi

Chart prepared by James Stanley

When Good News Goes Bad – Something Else is Going On

Deductively speaking, when fairly common relationships begin to break down or at least diverge, there’s usually a reason for it; even if that reason is not immediately obvious. In many cases, the price action will lead the ‘reasons’, and by the time we find out what was the primary cause of the driver, a large portion of the move has already been priced-in.

The selling in the US Dollar this week went along with continued selling in US Treasuries, and the jump in yields across the US Treasury curve over the past couple of months is becoming increasingly difficult to ignore. After hovering around 2.4% for most of December, yields on the 10-year Treasury Note crossed the 2.9% marker yesterday, and we’re fast approaching the seven-year high at 3.04%. So, this is a relationship that we can begin to draw from as the past month and a half have seen both a strong dive in the Dollar to go along with an aggressive jump in US yields.

US Treasury 10-Year Yield, Monthly Chart: Fast Approaching Seven-Year High, 3.04%

us treasury 10 year note yields

Chart prepared by James Stanley

Long Bonds Beware

For bond investors, or perhaps more to the point, bond traders, the current backdrop is likely one of fright. Prices and yields move inverse, so if you’re long US government bonds in a rising rate environment, the threat of losing principal or taking a hit on price is rather high. If you’re holding the bond to maturity, as it appears the Fed is planning to do with much of their portfolio, this risk can be mitigated to a degree, offset by lackluster returns from the lower-yields that you locked in before rates moved-up. But – if you’re trading that bond and not holding it to maturity, the principal hit that can come from rising rates can be rather large, and this is referred to by the financial term of ‘convexity’, or the principal move in a bond given a corresponding move in rates. This is what will usually allow rates to run-higher in a faster manner than rates might go down, because the old saying of ‘up the stairs and down the elevator’ often holds, even if we’re talking about bond prices.

Ever since the Fed tapered QE and started to hike rates, it’s been somewhat of the elephant in the room: With the Fed continuing Open Market Operations, long bond holders had the comfort of the Central Bank being on the same side of the trade as they are or were. Inflation has largely remained manageable and there were few reasons to worry about significant erosion of yield as higher rates of inflation ate-into real returns on bonds.

But as that inflation has started to creep-higher, bond traders have found another challenge to contend with, and that’s a massive increase in supply as the US government looks to expand. Tax cuts are estimated to bring an initial cost of $1 Trillion over 10 years while Congress just approved an additional $500 Billion in new spending over the next two years. That money will largely come from the sale of government bonds as the US government raises funds to finance these initiatives. This would also be a bit unusual from a timing perspective, as governments generally look to expansionary efforts in times of economic malaise, looking to help spur activity within their economy. But, by and large, the US is in an expansionary environment so the idea of posing a massive expansion to government spending would be a bit unique. But, none-the-less, that’s what we have.

So – if you’re a bond trader or investor and you’re holding a portfolio of US paper – the horizon shows that the same government that’s been back-stopping your trade for the past nine-years of QE-fueled flows is now going to be selling bonds in the open market in order to raise capital. This additional supply will likely lead to lower prices, which will also bring higher yields; and if you’re long bonds at the moment, you have the very real threat of being on the opposing side of the trade from the US government; not a great place to be.

And, last but not least, bond traders aren’t stupid. If the risk of holding long bonds isn’t justified by the possible reward, they’ll look to bail, and perhaps even direct their attention towards Europe or Japan, both places that have Central Banks still actively driving QE, backstopping those trades, for now.

EUR/USD Pulls Back From Fresh Three-Year Highs

Those fresh three-year lows in the US Dollar helped to bring fresh three-year highs in EUR/USD. Given that ‘DXY’ is more than 57% Euro, this makes sense. It also makes trading either at the moment rather difficult, as we’re seeing quick retracements in stretched moves on a Friday ahead of a three-day weekend. For swing and position traders, this is often the best time to institute prudence in only looking for setups that are worth the weekend risk.

In EUR/USD, we’ve seen a rather aggressive bout of selling after those fresh three-year highs printed in the overnight. Prices have dipped back-below the 1.2500 psychological level, and traders going into the weekend can look for deeper levels of support. The prior area of resistance around 1.2388 could be such a level. Given that this is more than 170 pips away from the highs, if we get that print by close of business today that would mean that the pair went through a rather aggressive sell-off. So, confirming that support is actually showing will be key before looking to take on any top-side exposure.

EUR/USD Hourly Chart: Pulls Back From Fresh Three-Year Highs

eurusd hourly chart

Chart prepared by James Stanley

To read more:

Are you looking for longer-term analysis on the Euro, the British Pound or the U.S. Dollar? Our DailyFX Forecasts for Q1 have a section for each major currency, and we also offer a plethora of resources on our EUR/USD, GBP/USD, USD/JPY, AUD/USD and U.S. Dollar pages. Traders can also stay up with near-term positioning via our IG Client Sentiment Indicator.

--- Written by James Stanley, Strategist for DailyFX.com

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

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