The US dollar index (or DXY) is on the move, but what's next and why should you care?
It's important to understand the technical forces at play that set this move up in the first place (outlined in the first chart below), because they help frame how we got here, and what might come next...
Basically the DXY is about to face a key test on the upside, and the fact is only time and price will tell whether it ends up becoming yet another bull trap, or something else. Indeed, the US dollar index continues doing an exquisite job of delivering maximum pain and confusion to maximum participants.
You might not get involved in the US dollar directly, but it plays a key role in the risk/return outlook of many other asset classes and markets, so whether you're a bull, a bear, or something else, I think you'll find these charts helpful in framing the outlook.
With that in mind, let's get on to the charts!
1. After a False Breakdown the US Dollar is Surging..
First chart, and perhaps the most important chart for understanding short-term technical dynamics for the US dollar index: this chart shows the US dollar index against 50-day moving average breadth (for G10 currencies). There's 2 things to highlight here: 1. the price action around that uptrend channel; and 2. the classical technical pattern in the breadth indicator.
On that gently up-sloping trend channel, we saw an initial attempt at breaking down, this turned out to be a false breakdown, and as is typical the subsequent rebound was swift, and now the DXY is on-watch (but I'll tell you why in a second). As for the breadth indicator, clearly in hindsight it went significantly oversold, and is now approaching overbought levels.
What to watch for: the main thing to watch for is the integrity of that gentle, gradual up-sloping trend channel. The DXY is fast approaching the upper end, and given how robust that trend channel has been so far, we shouldn't naturally expect it to break on first contact.
That is, we are about to face the opposite situation of a month ago where the DXY was making an attempt at breaking down and became significantly oversold. So I would be watching out for the DXY to encounter major resistance at the upper end of that upper trend channel as the market becomes overbought. But if it breaks out of that trend channel to the upside then we'll need to think a bit about the chart below...
2. (..and yet) US Dollar Implied Volatility Remains Near a Record Low
I'm not the only one to highlight this, but it's definitely something I've been talking about a lot (in fact it is one of what I think are the 10 key charts to watch this year). Basically, USD implied volatility remains near a record low, and the reason this is interesting is because historically a lot of major and violent moves in the US dollar index came on the heels of the same kind of profound crunch in FX volatility. In other words, low volatility is a good predictor of future higher volatility, and vice versa.
What to watch for: that's why I imply, the thing to watch for is that if the US dollar index breaks out to the upside of that so far gentle and gradual short-term uptrend channel things could get interesting (well, that is if you find massive and disruptive market moves interesting!).
But equally (and this is where it gets nuanced/complicated), if the DXY hits the upper trend line and rolls over it could just as well set it up for a big move to the downside... and that's the only issue with the volatility signal: it helps form an opinion on magnitude, but is agnostic of direction.
3. Keeping (Longer Term) Perspective
In terms of the longer term perspective, and putting this short-term trend channel into proper context, the chart below helps frame things. My first impression when I see this chart is it looks like the DXY is in the last phases of a tired-looking bull market.
The US dollar index tends to go through long-term cycles of around 15 years in duration, and I would argue we are either at or near the turning point of another one of those cycles. I'm keeping tabs on a bunch of other factors such as valuations, sentiment, cycle indicators, and monetary policy trends, not to mention the global picture. The evidence seems to stack up for the bearish medium-term take, but I would have to admit that when a market gets moving the momentum can take up a life of its own, so as a US dollar bear I am short-term nervous about that call, but unflinching medium-term.
What to watch for: the main thing to watch for with a chart like this, as I kind of alluded to, is to keep perspective on the contrasting and sometimes conflicting short-term vs medium-term dynamics playing out in this or any other asset/market for that matter.
Final Thoughts and Bottom Line
Bottom line: the DXY is on the move, but it still faces a couple of key tests that should give bulls at least passing pause for thought. Whether it passes or fails the test, the 2nd and 3rd charts provide some important historical context for what might come next.
It's always important to keep track of the outlook for the US dollar. It would be perhaps an oversimplification to say it's the only thing that matters for asset classes like commodities and emerging markets, but it's certainly a major factor. If the DXY breaks out of that uptrend channel and we see a turn up in implied volatility, it could set the stage for a sharp and disruptive move that ripples (negatively) across global markets. Though I am medium-term bullish both emerging markets and commodities, I'm wary that from a tactical perspective the US dollar is certainly a swing factor, so short-term risk management is front of mind as I update my mental models and my excel models.
For more detail on this this topic or any other specific questions get in touch...
Head of Research at Topdown Charts Limited