Is It Make or Break for the US Dollar Index?

You’d be hard-pressed to find another ticker with as many contradictory views as the DXY. The dollar has such an enormous influence over the global economy that it’s almost impossible to arrive at a consensus as to what it’s doing, why, and where it’s going. In this article, we will look at some of the facts that the bulls and bears are drawing attention to in order to make their respective cases.

The Bears Say:

The upcoming US elections are negative for the dollar’s mid-term prospects. With Democratic candidate Joe Biden currently leading the polls over President Trump in several key states, many are viewing a potential Biden presidency as a threat to a range of policies that have been favourable to Wall Street. As the elections draw nearer, there’s a possibility that investors could be looking to the euro or the yen as an alternative, at least until the dust settles.

The tentative truce in US-China tensions has been almost completely undone since the global spread of the coronavirus pandemic. President Trump has been ratcheting up hostilities between the US and China as he continues to play the blame game. What started out as tit for tat finger-pointing and flight restrictions between the two superpowers has escalated to Trump threatening a ban on the Chinese-owned TikTok and WeChat apps within the United States.

The President is also reportedly offering tax benefits, encouraging US firms to move their factories out of China. When the US-China tensions first escalated in earnest after President Trump began imposing tariffs and other trade restrictions on Chinese goods in 2018, the US Dollar Index fell to its lowest levels since 2014. It is now trading just over 4% above those former lows.

On the technical side of things, the end of July saw the DXY breaking below an important ascending line of support that has held firm for 9 years. It held firm when the index previously bottomed out in 2011, 2014, and 2018. The loss of this long-term support level is a highly ominous sign for technical traders, especially since the DXY has continued to drop below that line in August without so much of a sign of rebounding to retest it as resistance.

In the week of August 11th, the CFTC reported that USD net shorts had increased by a further $3.2 billion to an incredible $32 billion. This is the largest bet against the US dollar that we have seen since 2011.

Add to this a botched coronavirus response, a number of key frailties that the crisis has highlighted in the US economy, and the unprecedented monetary expansion that the Federal Reserve has been forced to conduct in response to the crisis, and you can see the bear case continuing to grow ever stronger.

The Bulls Say:

As far as Wall Street fears over a Biden Presidency are concerned, his pick of Kamala Harris as running mate is a move to appease both Wall Street and Silicon Valley. Kamala Harris is viewed as the moderate choice among a number of other more left-leaning candidates. Her pick, which has been praised by Hillary Clinton, is broadly viewed as being good for business-as-usual. She has been reluctant to support policies such as the breakup of the big tech companies and Medicare for all.

In her time as Attorney General of California, she scuppered the overturning of the death penalty. All the above put her squarely at odds with the more radical policies of other Democrats, as well as the protest movement that has been sweeping through the US this year. Add to this the mounting fears that Biden’s age and evident cognitive decline will not allow him to see his term through if elected, and you have the possibility of Harris taking the reins until the next election and then running again in 2024.

The enormous number of US dollar shorts recently reported by the CFTC (the highest number since May 2011) can certainly be taken as a bearish sign; alternatively, they can be read as an indication that the dollar is, in fact, reaching a bottom. If 2011 is anything to go by, the flurry of shorts seen in May of that year was followed by the DXY bottoming-out and then surging from around 74 to 84. For some investors, the overwhelming number of US dollar shorts is a sign of the laggards piling in just as the move down becomes overextended, which can mean that a reversal is imminent.

While the break below that aforementioned ascending support line doesn’t bode well for the dollar from a technical standpoint, it overlooks the fact that the euro is very overbought at the moment. The last time the Euro Currency Index saw weekly RSI levels this high was back in January 2018 (which was followed by a pronounced multi-year downturn). Additionally, the DXY’s RSI is currently as oversold as it has been since January 2018.

In fact, if you switch to the daily chart you’ll notice that the DXY is looking like it may be entering what appears like a bullish divergence (price making new lows while an oscillator like RSI fails to do so), while the Euro Currency Index appears to be doing the opposite; indicating a bearish divergence (price making new highs while RSI fails to do so). This is also a possible indication of a reversal of fortunes for both EUR and USD.

Finally, it seems as though we’re in a radically different situation today than when we witnessed dollar weakness during previous cycles. China is not embarking on any significant bouts of infrastructure spending. Emerging markets are unlikely to see a massive surge to strength any time soon as they deal with both the economic fallout of the coronavirus on commodity demand, as well as the spread of the virus itself within their borders. And with both Europe and Japan in the midst of their own deflationary spirals, this may be as good as it gets for the dollar bears. Watch this space.

by Giles Coghlan, Chief Currency Analyst at HYCM

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