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More Short-Term Weakness Likely for US Dollar, but a Turn Higher Looms Large


The charts of the euro and yen seem to be confirming the outlook for a bit more of a drop in the DXY before a major up move in both interest rates and the DXY occurs.

Last week brought us pretty much the ideal scenario for those long of risk assets right now: an accommodative ECB; a FOMC announcing that it was not altering its QE / bond-buying program for the foreseeable future; a slight positive surprise on the Chinese manufacturing PMI; and a US non-farm payrolls number that wasn't too hot, wasn't too cold, but just right. In addition, there were other data points, like a better ISM manufacturing number and a decrease in weekly jobless claims, that served to keep the bears on the defensive.

While some frustrated (bearish) market analysts point to the tepid nature of this economic recovery as a non-confirmation or bearish divergence of the equity markets' bull run, they fail to understand or acknowledge that the economy and the markets actually have very little direct correlation historically. One of the few relationships that can be shown relatively consistently over time is that the markets are a forecasting mechanism and not a confirming mechanism. As such, the equity markets should have and have had little meaningful reaction to most backward-looking numbers. The one exception to that statement would be, as I've shown previously, the 4-week average of weekly jobless claims – and that average has been trickling lower recently (favoring the risk bulls).

So, as a result of the news flow and central bank actions recently, traders have seen equities breaking to new highs and bond yields range-bound (to the delight of the Fed). Commodities have been mixed, with gold and silver rebounding, crude oil range-bound between $100 and $110, copper catching a bid off of China's upside surprise (PMI last week), and agricultural commodities under major pressure.


What about currencies? What are the biggest, most liquid markets in the world telling us right now about the dollar, yen, and euro?

US rates and the DXY were whipped around last week but remain below resistance.

All that data and news early last week served to push interest rates and the US Dollar Index up to resistance at 2.723% and 82.42, respectively. Friday, however, the US non-farms payroll data came in slightly below expectations, and both the interest rates and the US dollar reversed course and headed lower rapidly (away from resistance).

So what happens next for the dollar? Will the US bond vigilantes succeed in pushing rates up through resistance and confirming that a new secular bull market in rates (bear market in bond prices) is underway? Or will the Fed succeed in keeping rates contained – thereby continuing to allow for asset prices to rise in what appears to be a no / low inflation environment?

In the first scenario, the DXY would likely react bullishly to the vigilantes' success in crushing bonds / boosting rates. A breakout above not only the 82.42 level but up through the July peak at 84.75 would almost certainly occur if rates broke out.

In the second scenario, where the Fed succeeds in keeping rates contained, one would intuitively think that the DXY also would remain subdued. However, unlike rates, when looking at the US Dollar Index, we have to consider what may be happening with the countries and currencies with whom the US dollar trades.

Euro and Yen Outlook

The two biggest components of the DXY are Europe and Japan. The current narrative out of Europe seems to be that things are improving off of a very low base economically, which is giving the euro a temporary boost. There appears to be room for the euro's rally to continue before key resistance is tested at just above 1.34.

The narrative out of Japan, though, is less clear. One week, we hear rumors of Japan employing more hawkish fiscal and monetary policies to straighten out their balance sheet, thereby boosting the yen. Another week, we might hear about Japan's Abenomics continuing to remain in effect, thereby keeping a lid on the yen. All of these fundamental cross-currents are enough to make traders' heads spin, which is why so many are now watching the technicals so carefully. Based on the chart below, it appears like the yen could / should continue to correct higher in the short term – perhaps until 1.07 is tested on the upside.

Technical Outlook for the Greenback

So, with the help of the short-term upside that is likely to continue in the euro and yen, I am calling for some more downside to occur in the greenback in the short term. This selling should take the DXY down to 80.71 - 81.13 from 81.96 currently. Once the DXY establishes a low in the short term, my call is for a very sizeable rally in the DXY to occur, coinciding with a resumption in bearish action in the euro and eventually in the yen. This anticipated rally in the DXY will likely create new multi-year highs and may test the June 2010 peak at 88.71.

Summing It All Up

So, switching from technical to fundamental to wrap things up, the Fed may succeed in keeping rates under wraps for a bit longer, but (if I am correct in my forecasts) they may lose control of rates and the US dollar sooner rather than later. I must note that that this outlook will be invalidated by a close below 80.71 for the DXY – so traders would be wise to earmark that level when constructing their investing / trading plans.

For my part, I will be watching for good entry points in:
  • the ProShares Ultra Short 20+ Year Treasury ETF (NYSEARCA:TBT): right now, $75.18 looks like the best shot to get in;
  • the Power Shares US Dollar Bull (NYSEARCA:UUP): looking at an $21.95 entry if all goes according to plan;
  • the ProShares Ultra Short Euro ETF (NYSEARCA:EUO): looking at an $18.18 entry; and
  • the ProShares UltraShort Yen ETF (NYSEARCA:YCS): the entry here doesn't come until $54.52. Interestingly, there seems to be enough room to the entry point for YCS that it's bullish counterpart ProShares Ultra Yen ETF
    (NYSEARCA:YCL) may be a good short-term trade at current levels.
Twitter: @seachangereport

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