Stage set for a USD reaction

Price patterns over the last 12 months would suggest positioning in USD was very low pre the Covid19 breakout. Whilst nearly all other assets have reacted very strongly to the pandemic, the USD has not. Is there about to be a breakout of the recent trading range?

POSITIONING AND MOMENTUM:

Decades ago the legendary Gilt trader Colin Sarre taught me to monitor an asset’s Bollinger Bands to see if the market was positioned in that asset – if it was not, then “new news” to the market would have an outsized impact on that asset’s price.

A Bollinger Band (BB) is a technical analysis tool defined by a set of lines plotted two standard deviations (positively and negatively) away from that asset price’s simple moving average. These bands simply depict the recent price volatility - the lower the volatility and price movements, the tighter the bands and the higher the volatility, the wider the bands. When BBs are very tight, they demonstrate that the market has been trading in a relatively tight range, and that all news is “priced into” that asset’s price, and that therefore speculative positioning is low. This would also suggest that when “new news” would eventually hit the market, there would be a scramble to adjust investment allocations, as well as an entry of speculators looking to make short term profits on the “new news”. Note, however, that the BBs don’t give an indication about the direction of an asset price’s move – just that there will be a big move in its’ price.

The chart below shows the 45yr history of the price of the Dollar Index (DXY) and its’ monthly BBs (top graph) and the width of those BBs (bottom graph). It can be clearly seen that in the past big moves in the price of the DXY occurred when the BBs start widening from very tight band levels (indicated by the red shaded channel in the bottom graph). Those new trends in the DXY, after a period of low volatility and tight BBs, were always occasions when “new news” hit the markets (for example a change in fiscal policy, a change in fed monetary policy, an external crisis etc).

The chart shows that currently the BBs are as tight as they have ever been in the last 40 years.

Another useful indicator in understanding the market’s involvement in a particular asset is the asset price’s Relative Strength Index (RSI). It is a momentum indicator that measures the magnitude of recent price changes to evaluate overbought or oversold conditions in the price of that asset. It is displayed as an oscillator (a line graph that moves between two extremes) and can have a reading from 0 to 100, with a reading above 70 deemed overbought and below 30 oversold.

The large movements in asset prices since the Covid19 pandemic has caused ALL their RSI momentum indicators to move to either overbought (bonds, VIX, credit spreads) or oversold levels (equity, EM assets, commodities and leveraged country FX rates). Below are 9 charts that show RSIs at extreme high or low levels for various assets – I could add a further 50 similar charts given the high correlation between financial instruments:

The correlations between assets around the world are naturally high as Covid19 has impacted all asset classes globally. But throughout this entire market volatility and asset repricing, there are two assets that have seen no change in trend or large price revaluations – the DXY and Gold (I will not touch on the latter in a post in the future).

There has been volatility in DXY, as can be seen by the DAILY left chart below with momentum swinging from bullish to bearish and back to bullish - but there hasn’t been any material change in price. Note that the price tried and failed to break below the 200-day moving average (orange line) and that after flat lining for a long period of time, both the 50 and 200-day moving averages are beginning to rise. The weekly right-hand chart shows the attempt to break below the 55 week moving average support, which held just as it did last June. Price action seems to indicate a “buy on dip” market sentiment, but one where the momentum is NOT overbought AT ALL.

The chart that gives the clearest indication of the positive DXY market sentiment is that of the monthly prices (below). The March volatility can be seen in the arrowed candle, but in the grand scheme of things it’s pretty insignificant. What is far more important is that the 20mth moving average support (blue line) has not been broken and is rising and that the RSI momentum trend continues to build since it started in early 2018 (after the 2017 price correction). There is a huge price resistance at 102.35, a level last seen in Dec16/Jan17, which was tested and held last month. However the rising momentum suggests that it will be tested again soon, and if the momentum continues to rise, for example like it did in 2014, it will break through to the upside. Just for pure information, there would then be no resistance until the 2001-2002 double top of 120 (~ +18% from current levels).

MACRO THOUGHTS:

There will be some market analysts scratching their heads, as normally the DXY depreciates when in the past US interest rates declined and converged to European or Japanese interest rates (or even went under EUR rates). This is because USD carry (interest income) becomes relatively less attractive to investors in those countries, so they will invest at home and not in the US. So how come the $ is now appreciating given the recent 100bp decline in US rates towards European and Japan interest rates, as marked by the red oval in the chart below?

There is very good precedent for a breakdown in the relationship between the $ and interest rate differentials, notably during the last period of deleveraging around the Great Financial Crisis (GFC). Since 2009, the correlation between the change in value of the DXY and the interest rate differential between the US and EUR has been high (below left). But crucially, between 2007 and 2009 this correlation broke down (bottom right).

There was a dollar shortage during the GFC deleveraging that resulted in a spike in the DXY, despite the sharp decline in US interest rates to those of Japan and Europe (left hand red box in chart). Compare that move in 2008/09 with the recent moves in the DXY and interest rate differential since the Covid19 pandemic broke out – they look very similar, which would suggest to me that there is a dollar shortage.

As mentioned in previous posts, whilst the Global economy was faring well before Covid19, the fundamentals were all but good due to the extreme leverage in the private sector, both in DM and EM. The slowdown in growth will naturally bring a deleveraging if Central Banks only provide a liquidity solution to what is a Solvency problem and Governments and banks are slow to step in and lend money (see Page 342 : Irving Fisher’s steps 4 to 9). The current EM travails will surely necessitate IMF/World Bank intervention, but as their economies unravel, their thirst for $s should continue keeping a bid for the DXY.

CONCLUSION AND CONSEQUENCES:

• The reaction of the DXY has been relatively muted to the unfolding global slowdown, despite BBs showing that positioning was very light pre Covid19.

• Indicators suggest bullish momentum is gaining and that the 120 double top will be retested.

• The unravelling of EM and DM private sector deleveraging should keep a strong bid for DXY until governments step in with anti-deleveraging (i.e. solvency, not liquidity) measures.

• A stronger DXY will have disinflationary consequences for the US and a negative impact on US corporate profitability (due to lower overseas earnings). This would be a further “pain trade” for EM and all those who borrowed in USD without USD debt servicing cashflows.

• If the DXY was to appreciate, the market should be braced for far heavier US and global intervention (which is probably why Gold is about to have another leg up, but will look at that another time!).