The first thing that leaps out at you when viewing the entire history of the DXY is that it has been significantly higher in the past.
So much in 2021’s global outlook seems to be hinging on the US dollar’s continued weakness. Regardless of whether a synchronised global reflation based on fundamentals is in the cards or not, many investors are banking on the next best bet; that commodity inflation will be the unavoidable result of so many more dollars in circulation. To make this argument even more convincing, both the Fed and new Biden administration appear to have no choice other than to provide further stimulus, both monetary and fiscal. The question is no longer if, but rather, how much? In such an environment, can the DXY hope to continue holding above 90?
Why No One Wants Dollar Strength
In brief, dollar strength tends to hurt the global economy both in the developed and developing world. A strong dollar puts pressure on emerging markets, which tend to hold a lot of dollar-denominated debt. This can lead to slowing growth, currency crises, and recessions. Domestically, a strong dollar can lead to uncompetitive foreign exports, tightening liquidity conditions, and a levelling out or flat out drop in corporate profits in dollar terms. These also have strong implications for the national GDP. This is why Trump so often found himself on the warpath with trading partners and allies such as China and the EU.
A Brief History
It’s easy to forget that dollar strength hasn’t just been the result of the pandemic. Even at the levels the DXY reached in March of last year, it still fell short of its January 2017 highs, when it almost hit 104. This latest bout of dollar strength actually goes all the way back to the closing of the Fed’s QE3 program at the end of 2014. QE was followed by a steady stream of rate hikes from December 2015 to December 2018. Then, the Fed’s quantitative tightening program saw it retiring some of its debt, reducing its balance sheet from around $4.4 trillion in 2018 to around $3.8 trillion by September of 2019. This had the added effect of making dollars scarcer, on top of being costlier to borrow. This reduction of liquidity has now been widely accepted as the cause of the repo spike we witnessed in September of 2019, which put an end to QT and saw the Fed beginning to expand its balance sheet again. Then came COVID-19, and the rest is history.
The first thing that leaps out at you when viewing the entire history of the DXY is that it has been significantly higher in the past. In March of 1985, it peaked at around 128. In February of 2002, it hit 113, following the Dot-com bubble. Viewed on a long-term chart, the 100 level the DXY has repeatedly failed to remain above in recent years is merely the second lower-high since that 1985 all-time high. In fact, the DXY has been trying to break above 100 since February 2015. Last year’s spike above 100 saw it falling short of January 2017’s high around 104.
So, we have solid resistance at around 100, on a historically bearish chart that seems to be heading south. On the downside, the level everyone’s watching is the low of 88 the DXY reached back in 2018. This level preceded four consecutive rate hikes by the Fed, including the “step too far” hike of December 2018. Looking below, even the sub-90 levels we saw earlier this month don’t take the DXY into oversold territory, which means that a more substantial capitulation moment may be in store where it definitively breaks below 88. Especially if the euro, which accounts for almost 60% of the DXY basket, breaks above 1.25 against the dollar.
It’s perhaps notable that the two historical DXY spikes were relatively short-lived, whereas the coronavirus crisis has led to DXY returning to and failing to break above 2017’s high. What’s more, the price action between 2015 and 2017 has led to the formation of several RSI divergences, as you can see below. These can be meaningful enough on the daily chart, but on the weekly and monthly chart, unless they are in the midst of a bubble, they demand attention.
Investors are hanging on every word of US policymakers for any clue as to the sort of environment we’re to be looking at in the coming years. Fiscal stimulus will help to avert a solvency crisis that COVID-19 has exacerbated, and continued monetary stimulus will maintain the current liquidity conditions that seem to be conducive to dollar weakness and commodity strength. While not committing to higher treasury purchases as yet, the Fed has recently changed its language in the latest FOMC statements, signalling its willingness to keep rates near zero and to purchase at least $120 billion per month in treasuries and mortgage-backed securities. All this seems bearish for the dollar, notwithstanding any sudden shocks that will necessarily lead to a rush back to the dollar for safety.
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