Regardless of the prevailing economic data, US dollar perspectives never leave investors indifferent. Indeed, maybe bitcoin optimists will disagree, but the dollar remains the world’s premier currency, and its performance is
Therefore, it might not be a smart decision to ignore the recent discussion about “the death of the US dollar” caused by the poorperformance against the main currencies. You do not have to be an investment professional to understand that it is a good contrarian signal because this sort of talk rarely appears when the trend is still strong.
However, this information alone is insufficient to make a meaningful analysis, and that is why it is essential to focus on both technical and fundamental facts. In this regard, the first part of the analysis will be devoted to the primary (most important for USD – geopolitics, the Fed, and treasuries) market fundamentals and the second part will be aimed at technical view.
Geopolitical factor, which has been so much discussed, really matters. However, I would not make too much of it because it seems that the market has adjusted to a new reality, and the deep analysis of this factor would not make any difference. Indeed, dynamic geopolitical landscape distorted the market last year (Brexit), and it was maybe the best time to analyze its influence on the upcoming market trends. Lately, the market has not reacted strongly negative to the big surprises from Catalonia (October 2017) and the US election results (late 2016).
Nevertheless, looking at geopolitics through the lens of the volatility is very interesting. Indeed, growing political uncertainty on both sides of the Atlantic in the context of gradually decreasing market volatility is a source of concern. It all may eventually result in volatility spikes, and we should not forget about this threat.
Another important factor worth mentioning is the yield curve dynamics. This indicator has proved to be one of the best economic predictors. Studies haveshown that yield curve can predict the economic events approximately a year in advance.
Although the economic data may still bestable, the spread between the yields on 10-year bond and 3-month bill (see the picture below) is gradually going to zero. It is not a matter of recent months. This trend has been apparent since 2014. However, according to the study given above, the probability of the recession is approximately 6%.
Finally, a couple of words about the Fed. Due to the lack of sustainable positive economic performance, the consecutive rate hikes look like a preparation for the next recession, and nothing more. Financially speaking, QE leads to the overpaying across the main asset classes (including real estate) and narrowing of yield spreads. The overpaying gives rise to new asset bubbles. The narrowing of yield spreads results in “the hunting for returns”; investors are buying the riskiest assets. Under such circumstances, the financial system is at risk, and the Fed understands it.
The mechanics of QE leaves no way for painless recovery. The recenttaper tantrum history confirms the idea that there is no easy path to monetary policy normalization.
The bottom line is that risks are rising, and the only positive factor is the yield curve dynamics.
The fractal nature of every price pattern leaves room for different interpretations. However, in the picture below we undoubtedly see the inverse head and shoulders. The question now becomes how to work with such a pattern properly. Let us take a closer look at it.
The fact that neckline breakthrough has occurred is solid. In order to confirm the pattern, I propose that we examine some essential aspects. Firstly, we need to look at a momentum indicator. If the momentum is weakening, the price usually loses its power to make further progress. Secondly, we need to check a trend line from the head to the right shoulder. It is a useful tool, which marks a support area for an ascending price move. Thirdly, attention should be given to volume dynamics. We should see an increasing volume on the right shoulder. Finally, the price dynamics of the correlated asset. In a nutshell, it should confirm the price move of the analyzed asset. Here we take EUR/USD pair.
As can be seen in the picture above, RSI (one of the most famous momentum indicators) shows that the price momentum is close to exhaustion; however, we have not seen any retracement. The price is stable. The trend line based on the head and the right shoulder has not been touched yet. It means the uptrend is still strong. Examining the volumedata, we can easily notice that there is no significant difference between the left and right shoulders, but the big volume bar supported the breakthrough. To conclude, correlated asset dynamics shows the same chart pattern (head and shoulders).
According to the analysis, we may conclude that the pattern is valid.
The bottom line
The last several months for the US dollar were quite challenging. Strong dollar decline slowed down only a month ago, and even now, we cannot definitely say the downtrend is over.
However, the US dollar future seems to be quite optimistic. Firstly, the geopolitical factor with rising risks plays a role not only in the US, but also in other parts of the world. As the uncertainty increases, investors prefer to deal with cash or safe-haven assets. Secondly, although the yield spread is in a strong downtrend, the probability of recession is just 6% (it should not be confused with the probability of market correction).
Speaking about the market correction, during the last years the Fed has proved itself to be a market-dependent authority, not data-dependent. The recent rate hikes give the Fed some “bullets” to shoot in case of new economic or market downturn because the Fed understands the monetary easing shortcomings and its possible consequences.
This entire story plays into hands of dollar’s bulls. Furthermore, the first signs of a bullish trend (pattern on the US dollar index chart) start to appear.