The ICE US dollar index DXY is reeling under pressure and has fallen to multi-year support zone of 92-93. At the start of the year, most big brokerages and banks were bullish on the dollar and they expected it to rally in 2017, extending its bullish run that started post the US Presidential elections.
- The US dollar topped out in January of this year
- The DXY has fallen more than 10% from its highs and is likely to fall to multi-year lows.
- Most of the fall can be attributed to politics, rather than to a weak US economy
- The US economy continues to be strong and the Fed is likely to continue its tightening cycle
- If the Trump administration can pass a respectable tax reform, the dollar will rebound sharply
However, the DXY topped out at 103.82 on January 03, of this year and has fallen more than 10% since then.
So, is the dollar doomed or is this fall a buying opportunity for the medium to long-term?
Reason for the US dollar’s strength after the US Presidential elections
Donald Trump’s victory in the US Presidential elections boosted the dollar on hopes that tax cuts and higher infrastructure spending will invigorate the economy and force the US Federal Reserve to raise rates at a much faster pace than previously envisaged.
As a result, the DXY index rallied from a low of 95.89 on 09 November 2016 to a high of 103.82 on January 03 of this year, a gain of more than 8% within a short span of time. However, the DXY topped out at that level and has been in a downtrend ever since.
What has changed since then?
To start with, the President started deflating the dollar balloon when he said that the dollar was “too strong” during his interview with the Wall Street Journal on January 16 of this year.
Along with that, the repeated failure of the current administration in repealing the Affordable Care Act, also known as Obamacare increased the uncertainty around the tax reforms – a major event that will affect the dollar.
Though the Republicans are confident of passing the tax reforms before the end of the year, only time will tell whether they are able to achieve their target. As long as the uncertainty remains, the dollar will remain weak.
The dark clouds over the eurozone have dispersed for now
The eurozone had been facing certain events, which threatened the existence of the euro. After Brexit, the Italy referendum and the French elections were keeping everyone on the hook. However, all those events passed without causing any major damage. That boosted the confidence in the euro.
Additionally, the analysts expect the ECB to taper its bond buying program soon. Though the ECB President Mario Draghi attempted to sound dovish, the markets did not buy it.
Similarly, the UK has not fallen apart after the Brexit. As these currencies regain their composure, the DXY gets pressured, as it is the weighted geometric mean of a basket of currencies.
Nevertheless, it is not all doom and gloom for the dollar. There are some positives as well. Let’s look at them.
The US economy is on a strong footing
The US economy grew 2.9% in 2015, the best since 2005, but slowed down considerably in 2016 to only 1.5%. In the first quarter of this year, the growth was dismal at 1.2%, however, the economy rebounded sharply in the second quarter, growing by 2.6%.
The strength in the economy has encouraged the Fed to tighten twice already this year. Nonetheless, the market participants are divided about the third rate hike before the end of this year, according to the Fedwatch tool data.
Rick Rieder, Managing Director, Global Chief Investment Officer of Fixed Income at BlackRock believes that the Fed will not go ahead with another hike in 2017. He, however, believes that the Fed will hike three times in 2018. Overall, the Fed has made it clear that the era of low-interest rates is over.
Not only that, Janet Yellen has said that the Fed is considering unwinding its massive bond holdings “relatively soon”. Both these events are bullish for the dollar.
But, does the dollar always rally when the Fed tightens? Let’s dive into its recent history to find out.
How did the US dollar perform during the last three tightening cycles?
In the chart (sourced from ashraflaidi.com) above, we can see the dollar’s reaction to the three previous tightening cycles.
On all the three occasions, the dollar behaved differently. While the dollar fell sharply during the 1994-1995 tightening period, it had a nice run in 1999-2000 period. On the other hand, it was largely range bound during the rate hikes in 2004-2006.
Therefore, it is not necessary that the dollar will rise with every tightening cycle. It will depend on a number of factors, both within and outside of the US.
What can tip the table in favor of the dollar this time?
The current slide in the dollar is more to do with the political missteps rather than the condition of the economy. After failing to repeal Obamacare, the Republicans are likely to do their homework and come prepared with a credible tax proposal that can see the light of the day.
If the tax overhaul is noteworthy, it alone is sufficient to propel the dollar higher.
Other than this, the geopolitical tensions with North Korea, China, and Russia can also send the traders scooping the dollar, which is quoting at multi-year lows. After all, the dollar is the de facto reserve currency of the world and is considered to be one of the safe haven currencies.
Though the eurozone looks stable currently, it still has to deal with Greece and the Italian banks in the long-term. Any brewing crisis there is likely to send the traders back into the dollar from the euro.
What are the risks for the dollar’s recovery?
If the current administration cannot get any significant legislative bills passed, it will be a major downer. The economic recovery is maturing. Any signs of a weakening growth will send the dollar down the sinkhole. It is unlikely that the dollar will fall due to external factors.
What do the charts tell us?
Let’s first analyze the weekly chart of the dollar index. As seen above, the dollar has been in a range between 93 and 100.5 since the beginning of 2015. The index broke out of the consolidation following the US Presidential elections last year, however, it could not sustain the gains and fell back into the range. Since then, it has been in a sharp decline, quickly falling from the top of the range to the bottom.
The DXY has bounced sharply from the 93 levels on two previous occasions. However, this time, a breakdown looks imminent. Nevertheless, an important point to note is that the dollar has fallen without any major pullbacks and the RSI is oversold on the weekly charts.
Every time the RSI has dropped in the oversold zone on the weekly charts it is followed by a sharp pullback. We expect the same to occur this time too. So, should one buy now?
The daily chart shows that the downtrend in the dollar continues. It has broken below the 93 levels and is threatening to fall to multi-year lows. Therefore, it is not the right time to go long. We should wait for the dollar to stop falling and then initiate long positions with a suitable stop loss.