The US Dollar is to markets what groundswell is to long-period waves – that’s to say it’s one of, if not the most important driver for the entirety of global assets. Therefore, its movements, every bip, is hyper scrutinized by market participants.
With that, there’s currently an ominous pattern forming in the DXY, and the chart has been making its rounds on FinTwit, so we reached out to our network to ask them why this pattern, and why a potential breakout (up or down) matters.
In short, this matters because like it or not, the global economy runs on the USD standard. Global economic actors need it to engage in commerce with the rest of the world, and since the USD is the world’s major trade and funding currency, if the USD price rises [against other currencies], the world will be forced to allocate a larger percentage of their budgets toward acquiring dollars.
In this way, the dollar is a type of “Giffen Good”, wherein the demand for this commodity does not fall as its price rises, but rather the demand increases along with its price.
It also matters because rather than using the pullback in the USD price over the last 15 months to reduce their USD debt, foreign entities have actually increased their USD debt over that time period. This continued debt issuance denominated in USD increases future demand for USD (the debt must be repaid in USD), and as noted above, this demand does not abate as price rises.
Conversely, if the dollar rejects this inverse head and shoulders pattern and turns lower, it will relieve some of the funding pressures associated with a rising dollar, and the world may be able to continue with the global reflation theme which has been the consensus narrative for the last year.
If the USD breaks out significantly higher, it would likely be a significant negative for pretty much every risk asset on the board, likely starting with EM & commodities, followed quickly by US and developed economy equities.
Given that 2/3 of US GDP is consumption, and that US Net Capital Gains + Taxable IRA distributions are ~200% of Personal Consumption Expenditure (PCE) growth, any sustained decline in US equity markets is highly likely to drive a decline in US consumption, and therefore in US GDP and US tax receipts, which with debt/GDP at 130% would quickly push the US faster toward either a fiscal crisis (equities down, GDP down, UST yields up like we saw in March 2020), or a further upsizing of Fed QE (to finance what would be rapidly rising US deficits as GDP & tax receipts fell with stocks.)
The key question in our view is one of path – how quickly would a rising USD force the Fed and/or US Treasury to either jawbone the USD lower, or to actually act to weaken the USD?
The dollar has historically traded strong during risk-off periods in assets markets – which we characterize as inflation (inflationary risk-off) and deflation (disinflationary risk-off) in our framework.
As per our fundamental outlook for decelerating growth and inflation in both the US and global economies, we believe a market regime phase transition to deflation is likely to commence in the next six weeks – perhaps sooner.
There are three primary reasons the USD has an overwhelming tendency to appreciate against most other foreign currencies during risk-off market regimes:
Broad investor demand for safe-haven assets like Treasuries and “high-quality compounders” of dividends and/or secular growth in the deep, liquid US equity market;
Foreign multinational corporations transitioning cash balances to USD in anticipation of local currency depreciation and/or devaluation; and
Shortening rehypothecation chains leading to a decay in the growth rate(s) of leverage for both nonbank lenders and private nonfinancial sector borrowers.
Each of these three dynamics has a tendency to reflexively snowball, so it is important for investors to watch for signs of incremental dollar strength. At the current juncture, a sustained breakout above 6.5 on the DB Currency Vol Index (CVIX) (current reading) would be a clear signal to our models that deflation has arrived.
An inverse head-and-shoulders pattern tends to signal a bearish-to-bullish trend reversal; if the DXY makes a notable break above its neckline (~92.9), upside risk to USD would increase substantially in our view. In addition, EURUSD is testing key support on its own head-and-shoulders pattern; given the euro is the largest component of the DXY (nearly 60% of the index), if it breaks down, it will almost certainly push the DXY higher.
Net speculative futures positioning isn't as bearish as it was to start the year, but the setup is still quite similar to positioning in early 2018; the DXY rose more than 10% over the following 18 months.
Historically, a weaker dollar environment served as a tailwind for global growth and risk assets. The “synchronized global growth” narrative that characterized late 2017 / early 2018 coincided with one of the DXY’s worst years in 15 years. Similarly, the dominance of this year’s reflation narrative comes on the back of another period of dramatic USD weakness following a sharp move higher.
If the US dollar reverses trend, it threatens to throw cold water on some of this year’s most popular trades. Commodities, gold, emerging market equities, bitcoin are all vulnerable to a strengthening greenback, though the speed of its move also remains a critical factor.
Important to note not every technical breakout has a 100% hit rate; if the DXY breaks above its neckline and proceeds to fall back below prior resistance (i.e. a failed breakout) traders would be wise to cut bait and wait for the market to shake out.
The chart of DXY is signaling some deflationary impulses ahead, which seems counterintuitive in the face of ~$10 trillion of both monetary and fiscal support.
At the same time as the DXY is strengthening, we are seeing the US treasury curve flattening, which signals lower growth and inflation expectations in the future.
The growth of the entire global marketplace depends on US Dollar liquidity remaining abundant, so if the US Dollar breaks higher, I think that will also coincide with worse credit conditions.
Credit spreads, which are at almost generational lows, should widen as a stronger dollar is a signal of worsening liquidity and global growth. A weak US dollar is the fuel on which debt grows. If that switch flips, it can cause stress in global growth and credit.
I would look for the Biden administration to use this dollar strength to its advantage and unleash another fiscal infrastructure plan while the market continues to give him very advantageous rates.
Personally, I don’t see it as an inverse head and shoulders pattern (but many times charts are nothing but a Rorschach test).
Taking a wider view, it looks more like a bearish pennant pattern just above key long-term support at roughly 89. Fundamentally, the massive twin deficits should be bearish for the dollar over the longer term.
Shorter-term, I’m more concerned by the fact that small speculators in dollar index futures have recently put on their largest net long position in years. This is a key contrarian indicator that suggests traders may have gotten far too bullish on the greenback while the potential for a major breakdown is still very significant.
A break above the March 31 high would represent a higher high and a possible trend change but for now, the trend is lower.
Michael Nicoletos | Executive Advisor | @mnicoletos
This chart matters because the US Dollar accounts for more than 85% of all global transactions.
So naturally when the US Dollar strengthens a global "liquidity squeeze" occurs. Naturally, emerging markets tend to get hit the hardest and the reason is that EM countries have very volatile currencies so for them to borrow at cheaper rates they try to borrow in US Dollars where interest rates are much lower. As a result, when the US Dollar strengthens EM countries fill the pressure first.
Having said that, the speed of the squeeze matters more than the squeeze itself. Hence, if the US Dollar appreciates gradually then the problem can be mitigated for some time, until it can't anymore.
They say a picture is worth a thousand words so my answer on why this chart matters can also be found by pulling up the following four charts: DXY Inverted vs. CRB Commodities Index, vs. Iron Ore, vs. Brent Crude, and vs. Emerging Markets.
That's it for this publication. Hopefully, the USDs moves are put into a bit more perspective and a huge thanks to all of our contributors.
Co-founder & Head of Growth. Covers Energy, Markets, and Geopolitics. Ex-Goldman Sachs IMD, buy & sell side equity research, M&A, and head of strategy for media startup.
