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The Dollar May Be Down, But It Isn’t Out

September 25, 2016

After a rough period from the outset of 2016, the US dollar has found itself under increasing pressure following the Federal Reserve’s endless can kicking on raising interest rates.  With the latest meeting held earlier this week disappointing US dollar bulls once more, the selloff that transpired in the currency on Wednesday is likely to endure for another few sessions as market participants reevaluate the outlook for interest rates and monetary policy.  However, despite the near-term pressure on the US dollar, on a more medium-term basis, the fears of another downturn in the currency may be overblown.  Considering the Central Bank has signaled for one interest rate hike before the end of the year, any downturn in the US dollar is likely to be temporary and not permanent as a result.

The Wait and See Mentality Prevails

Despite heightened pressure on the Federal Reserve to act to adjust interest rates, the Federal Open Market Committee decided to hold rates steady at 0.50% by a vote of 7-3.  While the majority prevailed in this case, the growing dissent in the form of three votes for higher rates raises the possibility that the attitude of the FOMC is turning more hawkish after years of highly accommodative policy measures.  Nevertheless, the “for the time being, to wait” statement was also followed by revised guidance for the outlook, highlighting expectations for only 2 rate hikes in 2017 as opposed to the 4 initially anticipated.  This mirrors 2016 which has so far seen no hikes after forecasts of 4 successive rate hikes, with only 1 expected to occur in December with a 51.90% probability.

Typically speaking, dovish statements lead to downside in the local currency.  By contrast, a more hawkish statement and forecasts of higher interest rates is traditionally viewed as bullish for the local currency.  As such, even though the US dollar may be under pressure with no action on policy anticipated before December, it does indicate that any potential downturn in the US dollar may not persist.  With the US one of the only advanced economies that is considering higher interest rates when the broader global phenomenon is a focus on lower rates, this major divergence in policy may be the driver that causes the US dollar to rally significantly versus peers across the board.  Furthermore, should 2017 experience two rate hikes, any momentum higher in the dollar after the near-term retreat may embody a longer-term trend.

Technically Speaking

Looking at the 1-day candlestick chart of DXY which is the US dollar index, it is apparent that prices have been consolidating, or trending within a narrowing range over time referred to as a symmetrical triangle consolidation.  While normal horizontal ranges present tremendous opportunities due to the fact that investors can play both sides of the range by taking bullish positions at the bottom of the range targeting the top and bearish positions at the top of the range targeting the bottom, consolidations are not as advantageous.  For one, the narrowing range of prices means that the reward side of the equation is gradually shrinking while the risks remain largely the same.  As a result, when an instrument is consolidating, the best way to trade is to wait for a directional breakout instead of risking getting caught in the consolidation.

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As the Dollar index retreats, major level to watch on the downside is support at 94.73 which coincides with the upward trend line that began from the May lows.  Should DXY manage a candlestick close below the upward trend line and support, it could be an early sign of a breakout to the downside, especially if the momentum is accompanied by higher trading volumes and volatility.  However, should prices bounce of this level, it could suggest an inflection point in the price momentum that eventually leads to a rebound in the dollar index.  Standing in the way of any bounce are the 50 and 200-day moving averages which are acting as resistance.  Nevertheless, should the 50-day cross the 200-day moving average to the upside, it is a strongly bullish signal that will help restore upward dollar momentum.

Looking Ahead

In the meantime, the Federal Reserve is likely to remain its “data dependent” approach towards issuing guidance on monetary policy.  As a result, the two most important determining factors of any movement on interest rates are going to be employment and inflation.  Should job creation remain robust while accompanied by rising inflation and stronger growth, the Federal Reserve will have a stronger case for raising interest rates, catalyzing a rebound in the US dollar index.  However, should upcoming data come in weaker than forecast and create more dovish sentiment, it could derail any future rate hikes, keeping the downward pressure on the US dollar index intact.