Dollar To Remain On Strengthening Trajectory

Regular readers will know that we have been bullish the US dollar for some time, as a combination of technical and fundamental factors continue to align. From a technical perspective, the price action on the d ollar Index suggests potential for a resurgence of the g reenback over the coming years on both the monthly and quarterly charts. The monthly chart shows a tentative br eak above trendline resistance , and is combined with positive indications from momentum indicators such as the Relative Strength Index and the Moving Average Convergence Divergence indicator.

However, as we previously mentioned (see Factors Align For Equity Upside And US$ , May 30, 2013), it is important for us to see the break above resistance on the quarterly chart as well to suggest US dollar strength over the coming quarters.

In the 1995-2001 US dollar bull run, it wasn't until about 18 months from the decisive bottom on April 1994, in Q496, before the dollar broke out. Extrapolating from August 2011, when we think the US dollar index bottomed, a similar breakout would have occurred in Q213. The chart pattern looks reasonably similar this time around, and if and when the dollar goes, it will quickly move higher. The bigger picture here is that beyond the speculation about exactly when the Fed will exit QE and hike the funds rate, if the Fed actually raises rates in 2015 (in line with our forecasts), while the ECB, BoJ and BoE remain on hold or even ease further, the dollar is technically positioned to explode higher at some point, as it did in the late 1990s.

Dollar Bottoming Out
DXY Dollar Index - Monthly, With Relative Strength Index

Dollar To Remain On Strengthening Trajectory

Regular readers will know that we have been bullish the US dollar for some time, as a combination of technical and fundamental factors continue to align. From a technical perspective, the price action on the d ollar Index suggests potential for a resurgence of the g reenback over the coming years on both the monthly and quarterly charts. The monthly chart shows a tentative br eak above trendline resistance , and is combined with positive indications from momentum indicators such as the Relative Strength Index and the Moving Average Convergence Divergence indicator.

Dollar Bottoming Out
DXY Dollar Index - Monthly, With Relative Strength Index

However, as we previously mentioned (see Factors Align For Equity Upside And US$ , May 30, 2013), it is important for us to see the break above resistance on the quarterly chart as well to suggest US dollar strength over the coming quarters.

In the 1995-2001 US dollar bull run, it wasn't until about 18 months from the decisive bottom on April 1994, in Q496, before the dollar broke out. Extrapolating from August 2011, when we think the US dollar index bottomed, a similar breakout would have occurred in Q213. The chart pattern looks reasonably similar this time around, and if and when the dollar goes, it will quickly move higher. The bigger picture here is that beyond the speculation about exactly when the Fed will exit QE and hike the funds rate, if the Fed actually raises rates in 2015 (in line with our forecasts), while the ECB, BoJ and BoE remain on hold or even ease further, the dollar is technically positioned to explode higher at some point, as it did in the late 1990s.

Big Tests Ahead
DXY Dollar Index - Quarterly

From a fundamental perspective, three dynamics will remain broadly supportive of the US dollar strength. First, expectations for the Fed to start tapering off quantitative easing by the end of this year raises the prospects of higher interest rates in the US. As such, the carry trade appeal of EM will somewhat diminish, providing a boost to the US dollar . At yesterday's FOMC press conference, Bernanke did what everybody should have been expecting, which was play down near-term rate hike talk (e.g. by end-14), by stressing that rates could stay low even after 6.5% unemployment is reached. This outlook is consistent with what the Fed has said before, and there was relatively nothing new on the QE front: it still looks like tapering will begin in September of this year, and QE will end by mid-2014.

Second, anecdotal evidence suggests that investment into non-financial assets in the US such as housing, auto plants and high-tech manufacturing is picking up due the US' increasing attractiveness on the back of relative energy efficiency, rising wages in emerging markets and a steadily recovering U S economy. Lastly, the slowdown in growth, combined with near-record low yields and a rise in political risk in many key emerging markets suggests that the reward (relative to risk) has turned against emerging market assets for the time being, with the US providing both a safe haven and growth opportunities for investors.

Short Rates Driving US$/EUR

The relationship between the relative size of the Fed and European Central Bank (ECB)'s respective balance sheets has tended to correlate well with the US$/EUR exchange rate over the past few years. Looking at this ratio, and with QE3 continuing at a US$85bn/month pace, the dollar should be on the back foot.

QE3 Suggests US$ Weakness, But Expectations Now Becoming Paramount
Ratio Of Fed to ECB Balance Sheet And US$/EUR

However, at this point the major dynamic is anticipation of stimulus withdrawal in the US, and particularly its impact on short-term rates. The chart below shows German 2-year government bond yields minus US 2s, and US$/EUR, which shows a strong correlation between the two. With the Fed assuring markets that rate hikes are far from imminent, a strong bounce-back in the euro in the weeks to come would be no surprise. Longer-term, though, we continue to favour the dollar.

All About Short-Term Rate Expectations
Germany Minus US 2-Year Government Bond Yield And US$/EUR
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