US Dollar Fueled by Rising US Yields, Falling Fed Rate Cut Odds
US Dollar Forecast Overview
- As US Treasury yields run higher, the US Dollar (via the DXY Index) has been lifted back towards its yearly high. But given the interference of the September ECB meeting in EURUSD, the largest component of the DXY Index, traders may want to look at individual USD-pairs rather than the DXY Index.
- Fed funds are pricing in an 100% chance of a 25-bps rate cut in September and a 76% chance of 50-bps of rate cuts by the end of the year. Meanwhile, Eurodollar contracts are only pricing in a 56% chance of 50-bps of rate cuts by the end of 2019.
- Retail traders are turning more bearish on the US Dollar once again.
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Here we go again. Market participants are taking another ride around the ‘trade war news cycle.’ As we’ve previously noted, the cycle goes: (1) Trump administration is tough on China; (2) financial markets sell off on trade war concerns; (3) Trump administration hints at US-China trade deal; (4) financial markets rally on trade deal hopes; (5) No deal materializes.
As was noted on August 29, and still holds true today, global financial markets are firmly in stage (4). In previous spins through the trade war news cycle, stage (4) has been accompanied by higher US equities, higher US Treasury yields, and a stronger US Dollar. The driving factor behind all of these moves remains Fed rate cut odds.
US Treasury Yield Curve Remains Inverted
Now that the US-China trade war is in a short-term truce, US Treasury yields have turned higher as traders have lowered expectations for an aggressive Fed rate cut cycle. But this shouldn’t be a surprise; we’ve repeatedlypointed outhow Fed rate cutodds have been frontloaded to the US-China trade war.
US Treasury Yield Curve: 1-month to 30-years (September 12, 2019) (Chart 1)
While the 2s10s spread has moved in and out of inversion territory in recent weeks, the two key spreads of the US Treasury yield curve – the 3m5s and 3m10s – have been inverted for several weeks now. As a result, US recession odds increased over the summer. But with the US-China trade war in a state of truce as of the start of September, focus is now on the reduced potential for further aggressive monetary stimulus.
The Fed Rate Cut Cycle Looking Less Aggressive
As market liquidity returned after the summer last week, the start of September saw Fed funds futures discounting a 100% chance of another 25-bps rate cut in September and an 85% chance of a third and final 25-bps rate cut in December. There was a 24% chance of a 50-bps cut at the September Fed meeting.
Federal Reserve Interest Rate Expectations (September 12, 2019) (Table 1)
Now, Fed funds futures continue to price in a 100% chance of a 25-bps rate cut at the September Fed meeting, but since September 4, the odds of a 50-bps rate cut have dropped from 24% to 0% - in fact, there is now a 0.1% chance of a 25-bps rate hike. Meanwhile, odds of another 25-bps rate cut by December have dropped from 85% to 76%.
Eurodollar Contracts Agree with Fed Rates About Cut Cycle
Eurodollar contracts are now more closely aligned with Fed funds regarding the scope and scale of the Fed rate cut cycle. We can measure whether a rate cut is being priced-in using Eurodollar contracts by examining the difference in borrowing costs for commercial banks over a specific time horizon in the future.
The chart below showcases the difference in borrowing costs – the spreads – for the continuous front month/January 20 (orange) and the continuous front month/June 20 (blue), in order to gauge where interest rates are headed in the December 2019 Fed meeting and the June 2020 Fed meeting.
Eurodollar Contract Spreads – Continuous Front Month/January 20 (Orange), September 19/January 20 (Green), Continuous Front Month/June 20 (Blue) (March 2019 to September 2019) (Chart 2)
Based on the Eurodollar contract spreads, a 25-bps rate cut is fully discounted at the September Fed meeting. But there is only a 2% chance of a 50-bps rate cut; on September 4, there was a 56% chance of a 50-bps rate cut at the September Fed meeting. If there is a 25-bps rate cut at the September Fed meeting, Fed funds are discounting a 44% chance of a final 25-bps rate cut by the end of the year.
DXY INDEX TECHNICAL ANALYSIS: DAILY PRICE CHART (September 2018 to September 2019) (CHART 3)
The big picture for the US Dollar (via the DXY Index) is potentially troublesome, especially if the triangle’s bullish breakout attempt proves to be a failure after running up to a fresh 2019 high in the first week of September. A recalibration of the trendline support to account for recent price action suggests that the multi-month bearish rising wedge is still in play, leaving open the potential for major downside for the DXY Index.
DXY INDEX TECHNICAL ANALYSIS: DAILY PRICE CHART (September 2018 toSeptember 2019) (CHART 4)
In our last DXY Index technical forecast update on August 29, it was noted that “the symmetrical triangle in place over the past six weeks appears to be getting ready for a bullish breakout attempt. In clearing out the bearish outside engulfing bar/key reversal set on August 23, the DXY Index would have cleared out the most swing high, suggesting that traders should be on alert for prices to rally back to at least the 2019 high set in July at 98.93.” A fresh yearly high was set soon after, with the DXY Index rallying to 99.37 on September 3.
Even though the yearly high was established on September 3, the DXY Index’s daily candle that day proved to be an inverted hammer/shooting star; a concerning development for bulls. Indeed, price action has been uneven in the ensuing days, with the DXY Index returning to the 61.8% retracement of the 2017 high/2018 low range at 97.87.
Let’s put recent price action in context: as US Treasury yields run higher, the US Dollar (via the DXY Index) was lifted to a fresh yearly high. But given the interference of the September ECB meeting in EURUSD, the largest component of the DXY Index (57.6%), traders may want to look at individual USD-pairs rather than the DXY Index. During times of rising US Treasury yields, USDJPY tends to benefit – regardless of how other USD-pairs are trading.
USDJPY TECHNICAL ANALYSIS: DAILY RATE CHART (September 2018 to September 2019) (CHART 5)
In our most recent USDJPY technical forecast update on August 23, it was noted that “a bearish outside engulfing bar had formed on the daily timeframe…prior to a retest of the yearly low at 104.63, however, the August low of 105.05 might provide initial support.” Indeed, a fresh yearly low had been established soon after, with USDJPY dropping below the January 3 Japanese Yen flash crash low, falling to 104.45 on August 26.
Since hitting a fresh yearly low on August 26, USDJPY has essentially traded in a straight line higher. Rising US Treasury yields tend to help USDJPY more than other pairs given that the Bank of Japan keeps its rates held near 0%; USDJPY interest rate differentials are effectively determined by the USD-side of the equation alone.
In turn, USDJPY has made several significant technical progressions to the topside, breaking the June low and 76.4% retracement of the 2018 to 2019 high/low range near 106.78/97, as well as the descending trendline from the April 24 and July 10 swing highs. Now, USDJPY rates have traded back to the descending trendline from the April 24 and August 1 (bearish outside engulfing bar) swing highs near 108.00.
To this end, a close above 108.00 by the end of the week would increase the likelihood that USDJPY rates would return to a 30-pip area around the May 10 swing low and August 1 bearish outside engulfing bar high near 109.02/32.
IG Client Sentiment Index: USDJPY RATE Forecast (September 12, 2019) (Chart 6)
USDJPY: Retail trader data shows 57.4% of traders are net-long with the ratio of traders long to short at 1.35 to 1. In fact, traders have remained net-long since May 3 when USDJPY traded near 111.99; price has moved 3.5% lower since then. The number of traders net-long is 14.0% lower than yesterday and 17.8% lower from last week, while the number of traders net-short is 4.6% lower than yesterday and 4.8% higher from last week.
We typically take a contrarian view to crowd sentiment, and the fact traders are net-long suggests USDJPY prices may continue to fall. Yet traders are less net-long than yesterday and compared with last week. Recent changes in sentiment warn that the current USDJPY price trend may soon reverse higher despite the fact traders remain net-long.
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--- Written by Christopher Vecchio, CFA, Senior Currency Strategist
To contact Christopher Vecchio, e-mail at email@example.com
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