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US Dollar Forecast: Can Volatility Rise Alongside Trade Weighted USD?

US Dollar Forecast: Can Volatility Rise Alongside Trade Weighted USD?

Tyler Yell, CMT, Currency Strategist


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US Dollar Price Forecast Talking Points:

  • The ONE Thing:FX Volatility may be pulling a move similar to 2014, which in the short-term is disappointing, but in the medium term has traders licking their chops. The record low 2014 FX Volatility preceded a perfect storm that led to historical US Dollar strength
  • The broad concern when looking to the backdrop is that many central banks continue to ease with further easing priced in, which is expected to limit widespread market shocks absent an exogenous shock
  • The Federal Reserve US Dollar Trade Weighted Index is nearing the all-time high, and that seems to favor further DXY strength as well thought its heavy EUR weighting may limit upside

Technical Forecast for US Dollar / DXY: ST Neutral, LT Bullish > 95.15

Chart Source: ProRealTime charting, IG UK Price Feed. Created by Tyler Yell, CMT

The US Dollar posted a bearish key day on Thursday, May 23 when it hit a two-year high intraday, but managed to close below the prior day’s low. A bearish key day is famous for reversing broad sentiment in the market.

However, the low volatility environment and the favorable USD backdrop (to be explained below) makes the focus of the Bearish Key day to key support points mentioned above of 96.48, May 14 low, 95.15, March 20 low, & 94.50, the Year to Date or January 10 low. Therefore, a pullback to support before trend continuation higher is the anticipated view as opposed to an all-out reversal. A break below 95.15 would significantly damage the impotent uptrend structure, and only a move to a new YTD low below at 94.50 would turn the bias fully bearish.

A Look to G7 Volatility: DXY Rises Despite Low Vol

Source: Bloomberg, JP Morgan

Dollar bulls should take confidence (and many have) in the rise of the US Dollar in a low volatility environment. The inverse correlation of the DXY trend to the JP Morgan G7 Volatility Index that has arisen over 2019 is surprising but could pave the way for further US Dollar strength.

Last time volatility was this low; the US Dollar was moving sideways in the summer of 2014, which is similar to the current move though the trend has been tilted a bit higher as opposed to flat as in 2014. However, as you can see above, the rocketing higher of FX Volatility shown as the blue line above, aligned with the Dollar Index rocketing higher as well shown in orange.

You’ll notice these two have tracked together, and should a resurgence of volatility come; it could be quite US Dollar favorable. However, when volatility comes and should it come to a similar degree as H2 2014 is a trillion dollar question that only time can unveil.

Fundamental Insight: US Treasuries Favors Further USD Positive Capital Flow

Source: Bloomberg

The chart above is rather fascinating and can help show capital flows from global government bond investors, though admittedly it does not tell the full story. In short, the blue line shows the premium of the US Treasury 10yr Yield (presumably the safest investment in the world) over the average of the other G6 economies.

This US Yield Premium view is overlaid against the US Dollar Index in orange, but the broad takeaway is that the blue line may continue to fall if a global recession is upon us or the trade war intensifies as investors snap up relatively higher-yielding US Treasuries (currently at a 145bp premium to the 10yr G7 average less USTs).

The current trend really kicked off in mid-2018 where global investment flows seemed to buy US Treasuries via US Dollars that saw the premium shrink, and at the same time, saw the US Dollar appreciate rather aggressively. Additionally, as other central banks re-engage their dovish or accommodative outlook that could further take this trend of a shrinking US Yield premium further.

Traders should be on the watch for this trend to continue.

Fed’s Trade Weighted US Dollar Index Nearing All-Time High

Source: Bloomberg

Lastly, the chart above helps show that it is difficult to separate a trade war from a currency war. The blue line is the Federal Reserve’s Trade Weighted US Dollar Index, and it helps to communicate that a strong US Dollar can act as ‘weapon’ in a trade war if the strong USD continues.

While the Broad Trade-Weighted Dollar Index (TWI) has been more aggressive than the heavily EUR-weighted DXY, the correlation seems to favor that should the trend continue, and the TWI of the US Dollar continue higher, that the DXY may also follow suit.

While this chart isn’t shown, the correlation between FX volatility and the US Broad Dollar TWI has averaged +77.6%. Therefore, if volatility picks up, and the US Broad Dollar TWI follows suit, it’s fair to say the DXY may follow too.

Whether FX volatility or the US Broad Dollar TWI leads is a ‘chicken-or-the-egg,’ but unless the trend significantly changes, many roads seem to favor a stronger US Dollar Index absent a significant breakdown below the 95.15/94.50 2019 support zone.

We’ll see.

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---Written by Tyler Yell, CMT

Tyler Yell is a Chartered Market Technician. Tyler provides Technical analysis that is powered by fundamental factors on key markets as well as trading educational resources. Read more of Tyler’s Technical reports via his bio page.

Communicate with Tyler and have your shout below by posting in the comments area. Feel free to include your market views as well.

Talk markets on twitter @ForexYell

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