Coming into 2017, investors had high hopes for the US Dollar. It was up 3.5% in 2016, with all the gains coming from a strong rally that began at the start of November and culminated in the Fed’s hike on December 15th. It was then flat for the rest of the year. Investors were hopeful the consolidation after the huge rally from 2014 was finally over. The double top at 100.4 was finally broken and the dollar was ready for the next leg up. The Economist released their edition titled “The Mighty Dollar” on December 3rd. Speculators had amassed their largest long position since 2015 according to CoT data. Everyone and their pet rabbit was long dollars coming into 2017.
We all remember what happened next. The dollar had an intraday high of 103.82 on the 2nd trading day of 2017 and did not stop falling until the 3rd quarter of the year. The decline reached its nadir on September 8th when the dollar printed an intraday low of 91.03; a peak to trough decline of 12.32%.
It recovered slightly into the end of the year to finish at a 9.6% loss.
Coming into 2018, the situation seems to be the exact opposite. Everyone is forecasting the dollar to head much lower in 2018 and the general sentiment is very negative. Investors are falling over themselves to add to short positions or get short if they are not already.
We think the dollar is very likely to surprise everyone this year with a strong performance. Being short dollars is a very one-sided trade and those rarely work out. Borrowing from the famous Bob Farrell, “When all the experts and forecasts agree, something else is going to happen”. We present our case for a strong dollar in 2018 below, looking at it from a technical, fundamental and sentiment perspective.
The Technical Picture
While the dollar (in this analysis we us the DXY index as a proxy for the dollar) did have a large fall in 2017, it is still firmly in an uptrend. The support trendline put in place by connecting the lows from the middle of 2011 and the middle of 2014 has not been tested. This line is coming in around 86.5 at the moment so the price is above this level and would have to fall another roughly 3% to test it. A break below this trendline will invalidate our claim that the dollar will resume its bull market in 2018.
The dollar broke below important support a couple of weeks ago, around 91 – 91.30, defined by the 50% Fibonacci retracement from the 2014 lows to the 2017 highs and the low from September 2017. As the break was not quickly reversed, it must be considered as a genuine downside break. This was proven in the strong follow through to the downside.
From here, we see the dollar as having 3 paths forward. The first is a ‘V’ shaped recovery where the dollar bounces aggressively. It bounced perfectly off the 61.8% Fibonacci retracement from the 2014 lows to the 2017 highs. Just below this level is the 50% Fibonacci retracement from the 2011 lows to the 2017 highs. These 2 levels coinciding provides good support for the dollar. The bounce will have to clear previous support at 91 to be considered anything more than a counter-trend rebound.
The second is a consolidation pattern known as a ‘bear flag’. This occurs after a sharp drop, like the one that has just taken place, followed by a few weeks of upwards consolidation in a tight range before a plunge to new lows after which it will find support on the long term trendline.
The third is a sharp plunge below support at 88 to the trendline. If this occurs, the price will reach the trendline at the same time as it touches the bottom of the channel it has been in since the 2017 highs. This will give the price extra support.
We don’t have an opinion on which of the 3 is most likely to occur. We need to see at least 2 more weeks of price action before we can make a call with more certainty. What we would like to see is the third option. This will allow us to build a long position at a lower price than if a low has already been put in place for the dollar. Sharp, vertical plunges are also good indicators of the end of a trend.
Looking at momentum on a weekly chart, the 14 week RSI printed its lowest reading since 2008 and has created positive divergence with the price. MACD is also showing a positive divergence after printing its lowest reading since 2005! By positive divergence, we mean that the price has created a lower low but the momentum indicators have not. This is a reliably bullish signal.
Momentum extremes in one direction usually lead to extremes in the other direction so it has now become a tailwind for the dollar while it was a major headwind following its rally from 2014.
Seeing as the Euro makes up 57.6% of the Dollar index, it is worth taking a look at its technical picture. As expected, the chart looks like a mirror reflection of the dollar’s, albeit with greater volatility. It had a big decline in 2014 and has tried to rally back in 2017 after consolidating in between. On the flip side to the dollar, the Euro has recently broken above important resistance at 1.21, defined by the 2017 highs, and the 50% Fibonacci retracement from the 2014 highs to the 2017 lows. Like the dollar, we see 3 paths forward for the Euro.
The first is a sharp downwards reversal after testing the 38.2% Fibonacci retracement from the 2008 highs to the 2017 lows and failing to close above it. The reversal must close below the previous resistance at 1.21 to indicate it is anything more than a counter trend rebound.
The second is a consolidation pattern known as a ‘bull flag’. This is the exact opposite of the ‘bear flag’ mentioned for the dollar. After a sharp move to the upside, a few weeks of downwards consolidation takes place in a tight range before a sharp move to new highs.
The third is a spike to the trendline resistance at 1.27. If this occurs, it will reach the trendline at the same time as it touches the top of the channel, providing even more resistance. There are also a plethora of Fibonacci levels standing between the price and the trendline that it must clear. All in all, there is massive resistance for the Euro overhead between 1.25 and 1.27.
Again, we don’t have an opinion on which outcome is more likely. We need at least 2 more weeks of price action to make a certain prediction. As with the dollar, we would prefer a spike to trendline resistance as sharp vertical moves to the upside are reliable signals that the end of the trend is at hand.
Taking a look at momentum, the 14 week RSI printed its highest reading since 2007 before falling and forming a lower low while the price broke to a new high. This is a negative divergence. Similarly, the MACD printed its highest reading since 2011 and then declined, again confirming the negative divergence.
The Fundamental Picture
The biggest driving force of the EUR/USD exchange rate over time, which in turn is the biggest component of the dollar index, is the relative strength of the European stock market versus the US stock markets. We will use the ETFs EZU and SPY to illustrate our point. While US stocks weakened relative to EU stocks beginning in 2017, this underperformance ended in May and then had a double bottom in October before US stocks resumed their outperformance of EU stocks.
The dollar, however, continued to fall. As US stocks continue to outperform, it will put irresistible upward pressure on the dollar as investors buy dollars to invest in the US stock market. The divergence between the DXY (blue line) and SPY/EZU (red line) will not last and it will force the dollar to appreciate to “catch up”.
However, over the course of 2017, there was another, stronger driver of the EUR/USD rate, and hence the DXY. This was the spread between the yield on the 10 year German bond (known as the bund) and the yield on the 10 year US bond (known as the 10yr Treasury Note).
Like the above chart, the yield differential (red line) formed a double bottom in October and has rocketed higher since. The dollar (blue line), however, has languished in a consolidation pattern and has broken through its previous low after 3 months. With the yield on the US 10 year continuing to grow faster than the yield on the German 10 year, investors will rotate into US notes and out of German bunds. They will demand US dollars to make this purchase which will push the dollar higher.
Ditto for the relationship between the dollar and the spread between the US 2 year note and the German 2 year bond (known as the Schatz). This spread began rising in tandem with the dollar’s rise from 2014 but while the dollar fell in 2017, this spread kept going higher. The ‘jaws’ divergence will again put upwards pressure on the dollar as investors demand the safety and yield of the US 2 year notes over the German Schatz.
The Sentiment Picture
For sentiment, we prefer to use the data from the weekly CFTC’s Commitment of Traders (CoT) report. This is because this report details what investors are doing rather than what they are saying. Many other surveys just ask investor’s opinions on certain assets while the CoT tallies the positions actually held by speculators and commercials.
Towards the end of 2017, when the dollar bottomed at 91.07, speculators had amassed their largest short position since April 2014. This was right before the dollar’s rally from 80 to 100. They have increased their long position slightly following the dollar’s rally off the low but their positioning is still the most supportive for the dollar since 2014.
Another tailwind for the dollar is that the futures Open Interest has collapsed to the lowest since 2014 and has only recently ticked up.
Sentiment is only a reliable indicator at turning points but there is proof emerging slowly that a turning point in sentiment has been reached and that it is the most supportive of the dollar it has been since right before the 2014 rally.
Looking at the CoT report for the Euro, it shows that speculators have amassed their largest long position since at least 2012 (we don’t have a chart going back further). It is approximately twice as large as their long position right before the Euro bear market commenced in 2014. Open Interest is a little less than twice the size it was in 2014. As mentioned, the sentiment report is only useful at turning points and the latest report shows the speculator’s long position continues to grow but we suspect that if a false upside break is confirmed, speculators will start liquidating.
Such a large long position will cause huge downwards pressure on the Euro when the liquidation begins.
Our Outlook and Prediction
We feel that the dollar is poised for a strong rally to resume the uptrend that began in 2011. Technically, it will either rise quickly or it will decline further and find support on the trendline. From a profit perspective, we would prefer a dollar decline to the trendline as it will allow us to buy dollars at a lower price but are cognizant that a recovery may already be underway.
Momentum, after having been stretched to the downside, and printing some of the lowest readings in many years (a decade in the case of RSI!) have started rising and are showing positive divergence with the price. The new low in the dollar has not been confirmed by the momentum indicators.
The fundamental drivers all suggest the dollar should be much higher and if the outperformance of US stocks relative to their EU counterparts continue, it should force the dollar higher. Ditto for the yield spreads on the 2 year and 10 year notes.
Sentiment is the most supportive it has been for the dollar since the beginning of the rally in 2014. The huge long positions in the Euro will cause acceleration to the downside when the Euro begins to crack as speculators must liquidate these positions.
Our near term outlook is that a bounce may already be underway but this view may prove to be too sanguine so we are ready for a trend-ending spike down to the support trendline. Whichever outcome prevails, first resistance lies at previous support around 91.00. This is the first level that must be broken for any rally to be something more than just a counter-trend rebound 95 is seen as the next crucial level.
A rise above this level will clear the 100 and 200 day moving averages, as well as break out of the falling channel that contained any rebounds in the dollar during 2017. This is also the level at which the counter-trend rebound from the September 2017 lows ended.
If the price does decline further to test the support trendline, this level will roughly coincide with the 50% Fibonacci retracement from the 2017 highs.
All in all, a crucial level.
A break above 95 will see a test of 100 all but confirmed. A strong rally will see that level tested this year while a weaker rally will see it tested in 2019.
Charts are sourced from: