Return of the Dollar Bulls? Options Market Shows Bigger Upside for the Greenback
A less hawkish Federal Reserve was supposed to be the death knell for the U.S. dollar. Instead, the greenback has rallied for five consecutive days, defying a growing consensus on Wall Street that the currency is heading for darker days. Now, signals from the options market suggest more gains are likely in the short term.
Dollar Defies the Odds
The U.S. dollar index (DXY) strengthened Wednesday, reaching the highest level in almost two weeks. DXY rose 0.3% to 96.31, extending its winning streak to five days. Over that stretch, the greenback has gained 1% against a basket of its competitors. Prior to its recent run of good fortune, the dollar index had fallen to its lowest level in three weeks.
Interestingly, the rally began on Jan. 30, the day the Federal Reserve signaled a less hawkish path on monetary policy. In voting to leave interest rates unchanged, the Federal Open Market Committee (FOMC) said it will adopt a “patient” approach moving forward. Futures traders took this to mean that no further rate hikes are coming this year. In fact, Fed Fund futures prices reveal that markets believe a rate cut is more likely than a rate hike.
Futures traders may be putting too much emphasis on the Fed’s perceived dovishness. For starters, the central bank raised interest rates four times last year and signaled two upward adjustments are likely in 2019. Fundamentally, the only difference between the December rate statement and the one that was released last week was the bruising stock-market selloff. Although stocks began their long descent in October, it wasn’t until the back half of December that the turmoil reached epic proportions. Since then, stocks have rebounded more than 16%.
What’s more, Fed policy continues to diverge sharply from its counterparts in Europe and Asia. In these regions, a cocktail of stimulus measures is still being used to prop up national and regional economies.
What Options Tell Us
If one looks at the options market, they can clearly see that the dollar still has room to appreciate in the near term. As Bloomberg notes, contracts that appreciate if the greenback rises versus its competitors over the next three months are approaching their highest level since mid-December (that is, when compared to contracts protecting against a decline). Although the shift is relatively small, it could put downward pressure on competitor currencies and emerging-market assets.
As Bloomberg also noted, the dollar’s newfound strength has defied the growing consensus on Wall Street that the greenback is heading sharply lower by the summer. A median estimate of analysts polled by the news agency says the U.S. currency will fall 2.7% by June 30.
Let’s also not forget the turmoil surrounding some of the dollar’s biggest peers. The pound, which is the third-largest currency in the DXY basket, has just recorded its first weekly drop in six weeks. The declines were attributed to dismal economic data and the ongoing Brexit saga. Read more: GBP/USD Price Prediction: Cable Flood Gates Open to Fresh Wave of Sellers.
The yen is also contending with a sharp and sudden contraction in the Japanese economy. Japan’s gross domestic product (GDP) shrank 0.6% in the third quarter, the steepest fall since 2014. It was also the second time in three quarters that the economy contracted.
In the Eurozone, economic growth has virtually stalled over the last two quarters. The currency region expanded just 0.2% in Q2 and Q3.
Featured image courtesy of Shutterstock. Chart via Barchart.com.