Liftoff Setback Leads to U.S. Dollar Pullback
Currencies / US Dollar Aug 25, 2015 - 02:47 PM GMTBy: AnyOption
The US dollar has experienced a tremendous rally over the last year as the end of quantitative easing and prospect of interest rate normalization led to upside momentum in the currency. Expectations were largely set for a September rate hike with many FOMC voting members forecasting two rate increases before the end of 2015. However, with recent inflation data and the growing emerging market turmoil, the Federal Reserve might be forced to hold off with its most well intentioned plans, sapping downside strength and building the case for a deeper technical pullback in the US dollar index.
The Fundamental Picture
The US economy has largely experienced a lopsided recovery over the last year as certain areas outperform while others underperform. The wave of dollar strength largely impacted the export economy and industrial production numbers which continue to stagnate. While the housing sector continues to show robust gains, consumption has proven a mixed big and most consumers have been keep the purse strings tightened. Overwhelmingly, the prevailing conditions show that the economy has been re-leveraged after a period of deleveraging that followed the last financial crisis.
Instead of subprime home loans, the new normal for the American economy is subprime auto loans. The student loan bubble continues to grow despite a swelling number of delinquent borrowers. Moreover, the newly minted shale oil and gas industry looks set to see its own fortunes decline, with the potential to trigger a credit event across the high-yield debt space that bleeds into corporate debt. However, the Federal Reserve has largely ignored the risks of operating at the zero bound and the misallocation of resources that arises as a result. Nevertheless, the real problem facing the Federal Reserve is the lack of inflation.
With the consumer price index and other measures such as PCE inflation still well below the 2% targeted by the Central Bank, raising interest rates in a low inflationary environment could potentially trigger more problems in the economy. Even though employment has been heralded as the key statistic the Federal Reserve is following, with no anchoring of inflation, liftoff will be both challenging and damaging. In the meantime, expect the Federal Reserve to remain data dependent in its decision-making while remaining conscious of the external situation, especially the turmoil unfolding in emerging markets.
The Federal Reserve looks poised to postpone any potential rate hike until December at the very earliest after data revealed earlier in the month largely disappointed the Central Bank’s forecasts. Even though slack in the labor market has abated, labor force participation is ebbing near multi-decade lows, complicating the outlook. Maximum employment and reaching the inflation target are the two key metrics for the Central Bank. With no sustained rebound in inflation, raising interest rates could choke off remaining growth, further denting the recent string of losses in the US dollar index and clouding the outlook further.
The Technical Take
From a technical perspective, the outlook for the US dollar remains to the downside as the US dollar index experiences an increasingly sharp pullback following nearly a year of upside, with the index rising to the highest level since 2003 earlier in the year before retreating. First quarter GDP numbers sent the index tumbling to the downside where it has remained as the Federal Reserve outlook remains bleak. With the probability of a September hike now firmly below 30%, the dollar retrace is now in full swing as evidenced by the break of the key technical support level at 93.12 yesterday, indicating the possibility of sustained downside in the pair. Adding to the bearish case is the fact that the US dollar index remains below both the longer term 200-day moving average and shorter term 50-day moving average after the losses of the last few sessions.
While the dollar is attempting a relief rally after yesterday’s losses, it is likely to prove short-lived considering the growing capitulation to the downside. Since reaching the March highs, the index has been setting up in a descending triangle pattern, evidenced by the consolidation between the prevailing downtrend line and support at 93.12. While yesterday’s price action did not result in a downside breakout, a 30-60% retracement of the total move over the last few years would indicate a pullback ranging from 87.00-93.00. Basic technical analysis conventions expect that if the longer-term uptrend is set to continue, a downward correction would be necessary before a resumption of the trend.
The Outlook
The case considering the confluence of fundamental and technical analysis factors is acutely skewed to the downside as the Federal Reserve is forced to rethink its normalization strategy as the broader US economy struggles under the weight of a stronger dollar. Further weakness is expected as interest rate hike expectations are pushed further into the future while the dollar index undergoes as a correction after the last year’s momentum higher. Ideal Put positions will be initiated above the key support line at 93.12. A technical pullback as deep as 87-93 is likely before the prevailing uptrend resumes, adding to the downward bias in the pair. However, should inflation rebound and employment continue to make improvements, a rebound in the US dollar index could be sharp and quick, necessitating call positions once the correction has subsided.
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