The US Dollar has been on the spotlight since beginning of the year as momentum has surprised everyone. Retracements continue to be shallow. The dollar bullish trend is well mature on its own and I thought it's the perfect time to reinforce my view on the dollar as many are asking: what's next for the US Dollar?

This is the US dollar's fastest rise in 40 years, and it's up 14% on this year alone, and I was one of the few to speak about the dollar rally, even before the trend to be put in motion.

Explaining the dollar's incredible turnaround, at current speed and velocity is not quite hard to explain if you have been following my articles. There are plenty of evidences, from my side, as I was preparing for this kind of move. To understand better what it's happening with the dollar i'll suggest to go over and re-read my previous articles here:

This article's main objective will be to give you a road-map of next US Dollar phase and what to expect next. In this regard we're going to look on both fundamentals and techincals to try understand better the trend in motion.

  • The US Dollar Fundamentals
Part of the broad based dollar strength across the board is the huge divergence in monetary policy between the major Central Bank around the world.

Figure 1. Volatility across different assets classes

One element that makes the dollar going so high is the "risk element" that we're measuring in the markets. Volatility as a measure of risk trends is up for many different assets classes (see Figure 1 ) however it's the FX volatility in particular who has picked up and it's keeping its strength (see Figure 2) There is uncertainty in the FX market and lots of volatility due to major central bank policy changes like: SNB abandoning the 1.2 EUR/CHF peg, many CB cutting key interest rates (24 central bank rate cuts--> Global easing) and this uncertainty leads to risk which in turn makes capital shift towards a more stable currency which is the US Dollar as it can absorb huge quantity of money due to his large liquidity pool which makes it the only game in the town.

Figure 2. FX Volatility vs. US Dollar

The weak counterparts like the EURO is also contributing to the broad based dollar strength as the monetary policy divergences are a good reflection of the dollar strength. FED has also come one step closer towards first rate hike after removing the word "patience" from FOMC statement. But even thought they downgraded their economic forecasts from GDP, inflation and unemployment they are still on the path towards interest rates normalization cycle and if history is to provide any guide than we can use the last rate hike cycle to judge how things may unfold (see Figure 3) and based on the 2004 rate hike cycle, FED has proceeded with a rate hike in Jun, however it may be the case that this time around we may have a delay as the Fed funds rate suggest a first rate hike in September.

Figure 3. 2004 Rate Hike Cycle Timeline

Fed is one of the few major central banks around the global that is leaning toward tightening, which is in great contrast with other major CB like ECB, BOJ, PBOC which are easing and because of this precise divergence the US dollar has gain lot of traction.
The US Dollar is already up 14% on this year alone and it has an impressive run and even though in the short term the move may look like overbought, fundamentally speaking there is more space to the upside. The dollar bullish trend is still mature and the macro outlook remains unchanged in the long term, but noting goes in a straight line and corrections or at least a pause in the trend are healthy for the market and the overall stability of the trend.

  • The US Dollar Technicals

It's not unrealistic for the dollar to continue rallying as there have been other instances in the past in which case the dollar rally has extended past 50% mark (see Figure 5). Actually the dollar trade weighted cycles tend to last on average 8 years and we have still a long way to go. Many traders wrongly assume that because we have gone up in such a strong fashion way, we must go done.

But it's like in the physics laws of motion which state that a trend in motion will tend to continue in motion until a major event take place that would cause it to change its direction. So if you're looking at the chart and see momentum increasing and price making new highs, the odds are that higher prices will probably follow as momentum tends to accelerate as the trend develops.

Figure 5. DXY average 8 year Cycle

The Us Dollar move in big cycle tend to trade well above the 50% mark, we have two instances in the past (see Figure 6) that can serve as a road map for what may lie ahead of us:
  1. In 1980-1985 a staggering 95% rally which culminate with the creation of G5 and the biggest devaluation of the dollar(Plaza Accord).
  2. The 1995-2001 period produced a 51% rally, which was the trigger for the Asian Currency Crisis.
Figure 6 . DXY Advances expressed in %.

This business cycle is a reflection of the boom-bust cycle which is unfolding right in front of our eyes.

Taking in cosideration all my previous arguments we can strongly assume we're going to break above last swing high at around the round number 120.00 established in 2001. We can also tell that every major bull trend has started with the break of a TL(see Figure 7). The majority of the newly-developed trends have one thing in common: a broken trend-line from a previous trend. I wrote about this issue in more detail in my January article, you can find more here: Trend Trading Strategy: Departure Trendline Setup

Figure 7. DXY Monthly chart
  • US Dollar, Interest Rates and Bond Bubble cycle.

First rate hike is a significant event risk because the markets have already speculated about the outcome for this particular event as they are speculating on the eventual shift in FED's monetary policy. Even though it will be a slow process and most likely Fed will move gradually in the rate hike cycle and there will be no major hikes and Fed will try to keep rates below previous rate hike cycle pick, what matter most is this shift from easing towards tightening.

There is not an absolute correlation between the raise in the dollar and the higher interest rates. There are times when the dollar has fallen with higher interest rates, the key in differentiating dollar reaction are the business cycle and the capital flow. When it comes with currency market confidence is key as capital will flee towards the strongest country. Capital flees from the risk of geopolitical events regardless of interest rates and with the realization of a Bond Bubble ahead of us it'll send capital to the dollar.

We're in a debt bubble crisis and us such Fed action can be the trigger for the bond market crash. Usually bond markets start selling off 3 months ahead of the first rate hike and if bonds will start selling off after Fed's rate hike, there you have your first sign of what stand ahead of us. For sure there will be interesting times as the broad based dollar strength across the board will be the trigger for the next major crisis.

After 2007-2008 subprime mortgage crisis FED lowered rates to stimulate the economy and this low US dollar funding rates and easy leveraging have attracted many non-US borrowers (see Figure 8). This cheap dollar credit is what has created the massive short dollar position in the market, as when you borrow in a different currencies than your national currency you're basically short that currency. All that dollar denominated debt is becoming one of the weakest links in the global financial system.

That's why I've said that it's the outstanding short dollar positions that are fueling this trend, basically this is the pain trade because as higher the dollar goes the higher their debt repayment will go.

When the market positioning is heavy in one side of the market we know that usually the market goes the other way around. In this regard even though the dollar rally has gone to fast there is still a lot of room for it to go much more higher.

Best regards,
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