Friday, September 15, 2023
- The dollar is trading near an inflection point. A breakout above 106 would imply a bottom has been set in the greenback.
- Further upside in the dollar would create additional headwinds for most stocks and commodities. International developed markets could face outsized selling pressure based on their deeply inverse relationship to the greenback. On the commodity side, gold would likely underperform as it is the most negatively correlated commodity to the dollar.
- Despite the recent recovery, investors largely remain bearish on the greenback. Speculative net positioning in the dollar recently fell to over a two-year low, while risk reversals in other major U.S. Dollar Index components are trending higher.
- Next week’s Federal Open Market Committee (FOMC) meeting could be the make-or-break catalyst for the dollar. While the market expects a pause, any incremental hawkish tilt in monetary policy from the Federal Reserve (Fed) would likely propel the dollar out of its bottom formation. A dovish pause would likely lead to a pullback in the dollar, although downside may be limited if the eurozone economy continues to underperform.
The U.S. Dollar Index (DXY)— a basket of six currencies weighted against the dollar—has staged an impressive recovery after hitting year-to-date lows in June. Since then, the greenback has climbed over 5% due primarily to a stronger-than-expected U.S. economy and higher-for-longer monetary policy from the Fed. Of course, with currencies, it is all relative, and the dollar’s gains also came at the expense of euro weakness. (For reference, the euro holds the largest weight within the DXY at 57.6%.)
While the Fed is still battling stubbornly high inflation, they have made more progress against pricing pressures than the European Central Bank (ECB), which, unlike the U.S., is also contending with deteriorating economic conditions. Sticky inflation in the eurozone, including headline and core CPI readings of over 5%, prompted the ECB to raise interest rates for the 10th consecutive time yesterday. According to the ECB policy statement, “The key ECB interest rates have reached levels that, maintained for a sufficiently long duration, will make a substantial contribution to the timely return of inflation to the target,” although ECB President Christine Lagarde noted, “We are not saying that we are at peak.” The euro declined on the news and is now trading near its lowest level since May.
Euro weakness has translated into dollar gains. The DXY recently surpassed the May 31 high (104.70) and is now retesting a confluence of overhead resistance in the 105 to 106 range. Momentum remains bullish, although the Relative Strength Index (RSI)— a momentum oscillator used to measure the speed and magnitude of price action—has formed a short-term negative divergence from price action, creating some questions over the sustainability of upside momentum. Technically, a close above 106 would imply a bottom in the dollar has been set and leave the 107 to 108 range as the next resistance hurdle to clear. Support for the greenback sets up at 104.29 (20-dma) and near 103 (March 2020 highs/200-dma).
Dollar Up, Euro Down
Positioning Remains Bearish
Investors are positioned for a pullback in the dollar. According to Commodity Futures Trading Commission (CFTC) data, net non-commercial positions (speculators/non-hedging), based on total long vs. total short positions in the greenback, recently fell to their lowest level in over two years. As shown below, major tops and bottoms in non-commercial positioning have often coincided with inflection points in the dollar. However, more recently, positioning and the dollar have deviated, perhaps suggesting dollar bears have yet to capitulate on their trades. We suspect a breakout above 106 could underpin a short-covering rally.
Furthermore, risk reversals in the euro, yen, pound, and Canadian dollar—representing over a 90% weight within the U.S. Dollar Index—have been trending higher over the last 12 months. For context, a risk reversal in currency trading refers to the difference in implied volatility levels between out-of-the-money call and put contracts (volatility skew). Generally, a positive risk reversal is considered bullish as implied volatility in call contracts exceeds the implied volatility in puts, and vice versa for a negative risk reversal.
What Does This Mean for Investors?
Further upside in the dollar would create additional headwinds for most stocks and commodities. As shown below, the MSCI EAFE Index would likely see the most significant impact based on its deeply inverse relationship to the dollar. Gold could also see additional selling pressure if the greenback continues to climb. Of course, if the dollar pulls back and resumes its downtrend, the MSCI EAFE Index and gold would benefit based on historical correlation data, along with most S&P 500 sectors.
The dollar is close to breaking out from a major bottom formation. A move above 106 would imply a bottom has been set and a new uptrend is underway. Continued strength in the dollar would weigh on most equity markets, including international developed represented by the MSCI EAFE, which has been the most negatively correlated index to the greenback over the past year. Despite the recent recovery, investors largely remain bearish on the greenback, evidenced by speculative net positioning in the dollar recently reaching over a two-year low. Next week’s FOMC meeting could be the make-or-break catalyst for the dollar. While the market expects a pause, any incremental hawkish tilt in monetary policy from the Fed would likely propel the dollar out of its bottom formation. A dovish pause would likely lead to a pullback in the dollar, although downside may be limited if the eurozone economy continues to underperform.
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