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Dollar's Breakout Effort Falls Apart and Elections Volatility is Underpriced

Dollar's Breakout Effort Falls Apart and Elections Volatility is Underpriced

2018-11-03 10:00:00
John Kicklighter, Chief Currency Strategist
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Talking Points:

  • A break above 97 for the DXY and below 1.1300 for EURUSD were soundly rejected this past week
  • False break reversal potential rises, but volatility may interfere with traders’ plans for trends
  • See how retail FX traders are positioning in Dollar-based majors like EURUSD on the sentiment page

Technical Forecast for US Dollar: Neutral

The Dollar was on the verge of a critical bullish breakout this past week, but the effort fell apart just after the technical trigger was pulled. That shouldn’t come as a surprise as we have discussed the disparity between market conditions and technical stance for some weeks now. There are a host of remarkable technical levels for the various Dollar aggregates and key pairs like EURUSD, GBPUSD and USDJPY; but the presence of these milestones doesn’t alter the intent and convictions of FX traders. A break can pull in some short-term technical interest to fulfill a quick charge on momentum. However, there is limited confidence to facilitate the development of any serious trends. And, with the DXY Dollar Index attempting to push highs not seen in 16 months, a greater degree of confidence in follow through is necessary to make a productive transition. Seeing the DXY clear 97 temporarily may have drawn some over-ambitious bulls in, but the key proxy in EURUSD holding the line at its commensurate 1.1300 support meant a real groundswell had never even had a chance.

Chart of DXY Dollar Index (4-Hour)

Dollar's Breakout Effort Falls Apart and Elections Volatility is Underpriced

Deemphasizing the specific EURUSD influence behind the Dollar (which the DXY is heavily weighted towards), we see the march for the Dollar bulls was no less relentless. Below the equally-weighted index for the currency was slowly edging higher into a confluence of bullish and bearish leaning congestion zones. As the market ran out of room to move without committing, the measure forced a bearish break which represented the biggest single-day loss for the currency overall since March 2017. There is some immediate but moderate support stationed under the Greenback to take into account immediately upon the open next week. From the DXY, 96.00 was a resistance for October and the mid-point (50% Fib) of the 2017-2018 bear wave. A break below this floor would likely render more productive follow through than another attempt at 97 should it be speculative interests attempting the move alone. However, external motivation can change the level of volatility and momentum quickly.

Chart of Equally-Weighted Dollar Index (Daily)

Dollar's Breakout Effort Falls Apart and Elections Volatility is Underpriced

Two key themes over the coming week will vie for influence over the currency, and their complementary nature will make them somewhat difficult to untangle for how they are driving the currency. Below, we have USDJPY (candles) overlaid with the yield differential between the benchmark US and Japanese 10-year government bonds. There is a FOMC (Federal Open Market Committee) rate decision scheduled this week which will weigh in on the market’s treatment of the Greenback as either a carry currency or safe haven. It occupies both roles at the moment, and the confusion plays no small role in the Dollar’s lack of a clear path. If the Fed lowers its forecast for hikes, expect disappointment to start weighing in on the currency and to further amplify its response to any slide in risk appetite that may show through.

Chart of USDJPY Overlaid with the US-Japan 10-Year Yield Differential (Daily)

Dollar's Breakout Effort Falls Apart and Elections Volatility is Underpriced

Another distraction (in the lead up) and catalyst (after the fact) for the Dollar in the week ahead is the US mid-term elections. Given the weight of political risks in the global financial system these past months – trade wars, Brexit, Italy versus EU, etc – there is likely to be a close eye kept on this event. There is no doubt recognition of the uncertainty it poses for direction and activity level which has likely curbed the follow through this past week. However, implied volatility readings show that such concern perhaps underappreciates the impact the event may have. Below is the aggregate of expected (implied) volatility over the coming week through EURUSD, GBPUSD, USDJPY and AUDUSD. It is the highest in approximately 5 months but the level is still low given the circumstances. If the volatility that is realized overtakes what was expected, we may see short-term breaks with a little more run behind them.

Chart of DXY Dollar Index and an Aggregate 1-Week Implied Volatility Reading (Daily)

Dollar's Breakout Effort Falls Apart and Elections Volatility is Underpriced

Positioning remains one of the lesser appreciated environmental elements behind market movement that can take up the call for a more significant drive in the future. Below we have EURUSD overlaid with the aggregate open futures positioning behind the pair. This is one of the most liquid FX futures contracts, so it stands as the best proxy for market appetite behind the much more liquid spot instrument. We have seen a notable retreat in net exposure to the pair as it has retreat from 2018’s high of 1.2500/2600. And yet, the market is still showing far greater interest to the pair relative to average of the past eight years. This may very well show an anticipation for volatility which prompts exposure for speculative purposes or more ‘virtuous’ hedging appetite.

Chart of EURUSD and Aggregate Futures Open Interest (Weekly)

Dollar's Breakout Effort Falls Apart and Elections Volatility is Underpriced

Focusing our view of the derivative’s market exposure to the Dollar to the speculative ilk, we have found the past week that net positioning had nudged up to a fresh multi-year high this past week. This reading is released Friday with data that runs only up to Tuesday. So, the jump in net long interest occurred before Thursday’s sharp retreat. Not that would have necessarily signaled a full tilt retreat, but the longer the consolidation holds, the more capable the market is of rendering a reversal as a follow through on prevailing trend. The swing in net positioning these past six months still stands as an extreme move. I don’t like to treat such readings as immediate contrarian signals, but the positioning is nevertheless going to strain traders’ patience if progress continues to fall short.

Chart of Net Speculative Positioning in Dollar Futures Contracts (Weekly)

Dollar's Breakout Effort Falls Apart and Elections Volatility is Underpriced

Other Weekly Technical Forecast:

Australian Dollar Forecast: AUD/USD, AUD/JPY 2018 Downtrend Under Fire. EUR/AUD Price at Risk

British Pound Forecast: GBPUSD has Mildly Supportive Charts

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