U.S. Dollar: Rebound or Breakout?
- The US dollar has been under a significant amount of pressure in the past few months; the USD index is down 3 percent year-to-date.
- In the short run, traders are closely watching the 92.5 support; a breakout below that level will accelerate the downside move.
- However, we think that the USD index is set for a little bull consolidation towards the 94.5 level (which corresponds to the 38.2% Fibo retracement of the 92.5-97.7 range.
The US dollar has been under a significant amount of pressure in the past few months; the USD index is down nearly 10 percent since its high reached on March 20th and is down 3 percent year-to-date, which raises the question: how much can the USD devalue from current levels?
Even though the USD remains significantly undervalued according to a range of ‘fair’ value metrics, especially against the euro, we argued that developed economies (i.e. Euro area and Japan) cannot let the USD depreciate too much as it will dramatically impact their recovery, hence central banks will do ‘whatever it takes’ to smooth the volatility on their exchange rate in the medium term. We think that two ‘psychological’ important levels for the EURUSD and USDJPY are 1.25 and 100; central banks – the ECB and BoJ – will start to intervene when the exchange rates will start to trade above and below these levels, respectively.
Short-term USD view
The USD index recently hit important support at 92.5, which corresponds to the May 2018 lows, before receiving some bids with some traders taking profits on their short-term positions. We think that figure 1 is a good chart that summarizes the current positioning on the US dollar. Since the beginning of April, we highlight two major ranges on the USD index: the first is H1: 100.9 – L1: 95.7 and the second is H2: 97.7 – L2: 92.5, which are equal (5.2 points). When the USD hit the low of the first range at 95.7 in June, it consolidated higher to 97.7, which also corresponds to the 38.2% Fibonacci retracement of the 100.9-95.7 range, before it started to depreciate further in July. Hence, traders have been questioning if the USD index will repeat the same pattern this time and consolidated towards the 38.2% Fibo retracement again, which would be the 94.5 level.
In our view, further bullish consolidation on the USD index is very likely, especially considering the extreme moves we saw in July; to the exception to some EM currencies, it is rare to have prolonged periods of extreme moves in the G10 space without short-term periods of retracements. Hence, we would expect further upside gains in the short run, which should bring the EURUSD exchange rate below 1.1650.
USD and equities (S&P500)
Interestingly, we can notice a strong co-movement between the dollar and US equities in the past year (figure 2); a ‘Pavlovian’ relationship where a cheaper USD has coincided with stronger equities. Historically, we know that a stronger dollar has usually been associated with an outperformance of US equities relative to the rest of the world in the past 20 years. Hence, with equities trading close to an all-time high, being long USD at these levels could offer short-term investors an interesting ‘hedge’ in case risky assets suddenly start to experience a little drawdown in this ‘dry’ summer. We are not initiating any short positions on US equities, but we think it may be more rigorous to be long dollars in the near term if suddenly equities were starting to pull back some of their recent strengths.
Long-Term USD outlook
Even though a significant amount of investors are turning bearish on the USD in the medium to long term, with some expecting a massive bear consolidation up to 40%, we will clearly need to see a massive collapse in confidence on the dollar in order to assign a significant probability to this scenario. One popular chart that supports the USD devaluation argument is the famous ‘twin’ deficits (fiscal and current account), which has historically led to the USD index by 15 months (i.e. higher twin deficits lead to weaker USD). However, figure 3 shows that the downside on the USD tends to be limited, especially during times of crisis, as demand for the traditional safe haven eventually starts to pick up; for instance, the dollar started to appreciate drastically in the second half of 2008 (at the height of the financial crisis) despite the twin deficit pricing in a massive depreciation.
The other argument is that the titanic increase in the Fed’s balance sheet will constantly pressure the US dollar against all major currencies in the medium term. We do not buy that argument as not only the Fed usually acts as the ‘central bank of the world’ when liquidity dries up in periods of crisis, but other central banks such as the ECB or the BoJ could decide to intervene even more aggressively in order to prevent their currency from appreciating.
Hence, we are still not very convinced that the USD is set for a major bear retracement in the coming years considering the current macro environment and the significant political and economic uncertainty that could suddenly rise in European countries due to the elevated unemployment rates.
To conclude, even though the USD remains vulnerable in the short run, we still think that a retracement towards the 94.50 level at first is highly likely, which should weigh on the euro and the pound. We keep a tight stop slightly below the 92.5 level and would reverse our view in case the USD starts to retrace lower as breakout traders will take the opportunity to increase their shorts if the USD index breaks below 92.5.