US Dollar Forecast: DXY Index Rally Tracks Falling Fed Rate Cut Odds
US Dollar Forecast Overview:
- With traders less concerned about the Federal Reserve’s interest rate cut cycle, the US Dollar has been able to gain ground against its major counterparts.
- According to Fed funds futures, the timing of the next interest rate cut has been pushed back after Fed Chair Powell’s remarks today; and overall, have fallen since the last Fed rate expectations update last week.
- Retail trader positioning suggests that the US Dollar may continue to rally.
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Fed Chair Powell Holds the Line
Thanks to competing testimonies occurring on Capitol Hill today, Fed Chair Jerome Powell’s remarks to the Joint Economic Committee may have been missed by market participants. But for those that were tuning in, they heard similar tones to what was said at the October Fed meeting: the Fed has completed its mid-cycle adjustments, and is likely to be in a sustained period of keeping rates at their present levels for the foreseeable future.
With traders less concerned about the Federal Reserve’s interest rate cut cycle, the US Dollar has been able to gain ground against its major counterparts. While the initial capital shift from bonds to stocks reduced demand for safe haven assets in the wake of the October Fed meeting, the relative increase in US Treasury yields compared to other sovereign bond yields (see: German Bunds or JGBs) in attention to FX markets has helped lift the US Dollar as Fed rate cut odds drop and US Treasury yields continue to climb.
US Treasury Yield Curve Continues to Steepen
The US Treasury yield curve continues to move away from inversion territory over the past few weeks, riding comments from Fed officials that the rate cut cycle is finished. In part, much of this was driven by the notion that the US-China trade war is winding down, and accordingly, global growth concerns have receded.
US Treasury Yield Curve: 1-month to 30-years (November 13, 2019) (Chart 1)
The US Treasury yield curve continues to undergo “bearish steepening,” or when short-end yields rise slower than long-end yields. Historically, a bearish steepening of the US yield curve has proven to be a bellwether of improved sentiment among market participants, signaling expectations for higher growth and inflation. As the US Treasury yield curve has continue to steepen during November (the 3m10s spread moved from 18-bps on October 31 to 35-bps today), the DXY Index has gained 1.07%.
Fed Rate Cut Timing Pushed Back Further
According to Fed funds futures, there is now a 5% chance of a 25-bps rate cut at the December Fed meeting (or a 95% chance of no change in interest rates). Fed interest rate cut odds have been on a steady downtrend since the October Fed meeting, where Fed Chair Jerome Powell all but closed off the path to any further rate moves; his comments today did little to change the narrative.
Federal Reserve Interest Rate Expectations (November 13, 2019) (Table 1)
According to Fed funds futures, the timing of the next interest rate cut has been pushed back after Fed Chair Powell’s remarks today; and overall, have fallen since the last Fed rate expectations update last week. One week ago on November 6, there was an 85% chance of no change in rates at the December Fed meeting; one-month ago, there was a 53% chance. Last week, the next rate cut was priced-in for June 2020; now, markets are favoring July 2020.
Eurodollar Contracts See Diminished 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. Eurodollar contracts continue to be closely aligned with Fed funds regarding the scope and scale of the Fed rate cut cycle.
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), Continuous Front Month/June 20 (Blue) (May 2019 to NOVEMBER 2019) (Chart 2)
Based on the Eurodollar contract spreads, there is there is a 36% chance of a 25-bps rate cut by the end of the year –more aggressive than Fed fund’s implied probability of 5%. Through June 2020, Eurodollar contracts are pricing in a 100% chance of one 25-bps rate cut and a 10% chance of two 25-bps cuts; similarly, Fed funds are pricing in a 10% chance of two 25-bps by that point in time. The divergence between Eurodollar contract spreads and Fed funds is more about the timing of the next rate cut, not the magnitude or direction.
DXY PRICE INDEX TECHNICAL ANALYSIS: DAILY CHART (NOVEMBER 2018 to NOVEMBER 2019) (CHART 3)
In our last US Dollar forecast technical analysis update, it was noted that “the DXY Index has returned to the same trendline [from the February 2018 and June 2019 lows] once more, setting up an alternative scenario: a false bearish breakout…a close above 98.00, the October 30 bearish outside engulfing bar/key reversal high, would suggest that the downtrend experienced by the DXY Index since the start of October is finished.”
Indeed, the false bearish breakout appeared to be the correct perspective: the DXY Index has climbed through the rising trendline from the February 2018 and June 2019 lows, breaking above 98.00 in the process.
Accordingly, the DXY Index’s momentum profile has shifted from neutral to bullish. Price is above the daily 5-, 8- 13-, and 21-EMA envelope and the EMAs are now in bullish sequential order. Slow Stochastics have jumped moved into overbought territory, and daily MACD has trended higher to reach its median line. The path of least resistance is higher: the DXY Index may begin to see resistance near the August 1 high at 98.93.
USD/JPY RATE TECHNICAL ANALYSIS: DAILY CHART (NOVEMBER 2018 to NOVEMBER 2019) (CHART 4)
Since our last USD/JPY rate forecast technical analysis update on November 6, not much has changed. “USD/JPY rates have been trading in an ascending triangle pattern since the end of May, and for like at the end of October, topside resistance is in focus once more. The area around 109.31/40 is critical. A close above 109.31 would clear out the August 1 bearish outside engulfing bar/key reversal, as well as the 50% retracement of the 2018 to 2019 high/low range near 109.40, would suggest that a bottom has been found.”
The ascending triangle for USD/JPY rates remains in place. USD/JPY has fallen below its daily 5-EMA, but remains above its daily 8-, 13-, and 21-EMA envelope, which overall, is still in bullish sequential order. Daily MACD has started to turn lower (albeit in bullish territory), while Slow Stochastics have started to turn lower from overbought territory (note: a lower high established than in October, when USD/JPY rates were trading lower).
As such, it still holds that traders should be patient waiting for the breakout potential: a bullish breakout would be validated above 109.40; otherwise, the bear case would gain traction below the November monthly low, set on the first trading day of the month at 107.89.
IG Client Sentiment Index: USD/JPY RATE Forecast (November 13, 2019) (Chart 5)
USD/JPY: Retail trader data shows 48.58% of traders are net-long with the ratio of traders short to long at 1.06 to 1. The number of traders net-long is 1.32% lower than yesterday and 0.12% lower from last week, while the number of traders net-short is 2.91% lower than yesterday and 13.36% lower from last week.
We typically take a contrarian view to crowd sentiment, and the fact traders are net-short suggests USD/JPY prices may continue to rise. Yet traders are less net-short than yesterday and compared with last week. Recent changes in sentiment warn that the current USD/JPY price trend may soon reverse lower despite the fact traders remain net-short.
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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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