US Dollar: The New Bear Market?

By Jason Pearce

The Greenback In the Red

There is some compelling evidence that suggests that the multi-year bull market in the US dollar has come to an end.  Monetary policy, cyclical and seasonal patterns, and the technical outlook all make a good case of further weakness ahead.

If the US dollar does continue its descent, the first order of business for traders is pretty straightforward: you should be short the US dollar and long some of the other currencies.  That’s a “no-brainer” right there.

Now if you do not fancy yourself as a currency trader per se, don’t dismiss this conversation just yet.  You’re other investments may still be greatly affected by the trend in the US dollar.  Even if you’ve stuffed all of your cash under a mattress or converted everything to gold instead of holding one of those pesky fiat currencies, the trend in the value of that dollar still has an impact on your wealth.  It will determine whether you are gaining or losing purchasing power.  Being unaware of the trend in the greenback is irresponsible and staying unaware is downright foolish.

You should also pay particularly close attention to the trend in the greenback if you trade/invest in commodities and raw materials.  The effect of the US dollar’s trend is probably most noticeable here.  A rising US dollar means that US goods are more expensive to the rest of the world, so demand softens.  Price follows.  Conversely, a declining US dollar means that US goods are becoming cheaper to the rest of the world, so demand and price will rise.  This isn’t always the rule, but it stands true the majority of the time.

Interest Rate Effect

Interest rates are a major driving fundamental factor for currency trends.  In broad strokes, currencies trends are expected to move in tandem with interest rate trends.  If rates are rising, the currency should rise.  Conversely, if rates are declining, the currency should head lower.  This is Economics 101.

On the surface, the correlation between rates and currencies makes sense.  After all, investors are yield chasers.  They want to own the currencies with the highest yield in order to get the biggest bang for their buck…or Euro…or yen, etc.

In real life, however, it’s not always quite that simple.  Currencies often have a tendency to lead the target by factoring in the trend in monetary policy.  It’s a good example of that old Wall Street saying, “Buy the rumor, sell the fact.”  This does not happen every single time, but it does seem to happen quite often.  Often enough to wonder why you ever bothered to take Economics 101.

The current trend for US interest rates is higher.  On December 14th, the Fed raised rates for the first time in a year.  They hiked again in mid-March and are expected to do so yet again in June.  As a matter of fact, there are many economists and Fed members who see a couple more hikes before the year is out.

During this current trend in monetary tightening, it appears that the news of higher rates is discounted.  The US dollar index peaked on January 3rd a penny and a half higher than what the day’s high was when the Fed first hiked rates in mid-December.

When the Fed hiked again on March 15th, the greenback actually dropped about a penny and a half.  It has made a series of lower lows and lower highs since then.

If this current behavior pattern persists, the dollar could experience even more weakness at the mid-June FOMC meeting.  This would simply confirm that the tightening cycle has been completely priced in.

Presidential Cycle

The US Presidential cycle shows that the US dollar index often surges after the election, despite who wins.  This rally finally runs out of gas just before the middle of the year after the election.

This year, it appears that the expected peak in the greenback came early.  On January 3rd the dollar crested at a multi-year high and has been working its way lower ever since.

The second half of the post-election year starts in just a few weeks.  This is where currency traders should be paying close attention.

According to the US Presidential cycle, the second half of the post-election year is an ominous time for the dollar as the roadmap points lower for the next two years.  Bounces are expected along the way, but if this cycle holds sway, they won’t last long.  Rallies should be viewed as temporary events and short sale opportunities.

Seasonal Pattern

Based on the greenback’s seasonal pattern, we’re just a month out from where a major decline could commence.  This dovetails perfectly with the projection of the US Presidential cycle.  If so, the next few weeks could present an ideal timeframe to watch for a short sale opportunity.

Before we talk about this seasonal outlook, though, it is important to keep in mind that the seasonal patterns and cyclical patterns do not tell the US dollar what it has to do in the future.  These patterns are a statistical measurement that tells us what the market has done in the past and provides a projection of the most probable outcome moving forward.  Still, it creates a well-worn path that, if used properly, a trader can use to get an edge.

When I say used properly, I mean combining it with price action and giving the current price action priority over the seasonal and cyclical patterns.  If the buck follows the same path in 2017, trade accordingly.  But if the buck deviates from the path, do not try to force it into complying with your wishes.  The market will quickly show you who the real master is.

Now, onto the seasonal pattern…

The US dollar index has a seasonal tendency to peak in the first half of March and then decline until early May.  The buck stuck to the script for this part of the year as the March high was posted on March 2nd and the dollar headed lower for the next two months.

From early May though the start of July the greenback has a seasonal tendency to rally sharply.  So far, that has not been the case in 2017.  The buck has bucked the pattern as it moved lower throughout the month of May and recently touched the lowest price since the Presidential election took place.  This right here is a prime example of why traders need to obey price over seasonal patterns.

The first week of July is supposed to mark an important seasonal top that is followed by an overall decline until late October.  Around Independence Day, we should expect fireworks in both the literal and the figurative sense.  Currency traders should monitor the US dollar index closely once the second half of 2017 is underway.

A perfect setup from here would be for the greenback to make a bear market rally in June and then roll over after the first week of July.  If the buck bounces over the next few weeks, watch to see if there’s a moving average or chart pattern that supports the rally.  Also, observe how it reacts to technical resistance on the way up.  If the rally starts to erode once July starts, it could be a good clue that the next downdraft in the dollar has begun.

What Say the Charts?

On the daily timeframe, a Death Cross occurred on May 26th when the 50-day Moving Average closed below the 200-day Moving Average.  This is a well-known sell signal.  The last time it occurred was fourteen months ago and the greenback dropped for several more weeks afterwards.

More important than this Moving Average crossover signal, though, is the obvious bearish price pattern unfolding right now.  The US dollar index posted a multi-year high of 103.82 on January 3rd and then dropped to a low of 99.23 on February 2nd.  A bounce to a lower high of 102.26 on March 2nd was followed by a decline to a lower low of 98.85 on March 27th.

Once the Groundhog’s Day low was broken, the greenback had officially established a lower low and a lower high.  This downward trend has been confirmed as additional lower bounce highs and lower corrective lows have followed.  Until this pattern is broken, consider the US dollar to be in a well-defined downtrend on the daily chart.

On the weekly timeframe, the US dollar cracked important trend line support at the end of April.  The trend line was drawn across the May 3, 2016 low of 91.91, which set the low for the year, and the June 23, 2016 correction low of 93.01 that was established in reaction to the Brexit vote.

The US dollar index tested this trend line in August and September and then recovered.  The trend line really proved its worth during the Presidential election when it made a knee-jerk reaction and collapsed to a one month low, tagged the uptrend line, and then exploded higher just hours later.  The trend line confirmed its credibility.

After undercutting the Groundhog’s Day low on March 27th and touching the weekly trend line again, the buck bounced.  This was not a surprise.

The surprise came a month later when the bounce faded and the greenback opened ‘gap down’ on April 24th.  The US dollar had all week to recover the trend line, but it never did.  It has been below the trend line since.

Interestingly, the brief bounce into the May 11th high took the greenback right up to the bottom of the trend line and it immediately shrank back from it.  This confirms a classic charting rule: Technical support, once it has been broken, becomes technical resistance.

On the monthly timeframe, there are three ways that a case can be made that the multi-year bull market in the US dollar index has suffered a severe blow, maybe even come to an end.

First, there’s the Wash & Rinse sell pattern that took place.  The greenback initially had a double top established between the March 2015 high of 100.39 and the December 2015 high of 100.51.  The buck ran through this top back in November and negated the bearish pattern.  Just a couple of months later, the greenback reversed from making a new multi-year high to closing back under the 2015 top.  This failed breakout has bearish implications.

The second negative on the monthly timeframe occurred at the same time that the Wash & Rinse sell pattern was established.  The Fibonacci .618 retracement of the entire decline from the July 2001 fifteen-year high of 121.02 to the March 2008 multi-decade low of 70.69 was located at 101.79.  This important technical resistance was surpassed in November.  But like a junkyard dog running at full speed without regard to the chain around its neck and the stake firmly in the ground, the buck abruptly stalled out just a couple of pennies higher and was quickly jerked back down.  It appears that the Fibonacci .618 boundary is working.

Finally, the greenback finished the month of May below the 12-month Moving Average of its closing price.  Now, this bearish trend change signal does not always work.  Nothing ever does.  But you can see that a majority of the time it has led to lower prices in the months ahead or at least a multi-month consolidation period.  It rarely pays to bet against this bearish trend change signal.

Different Shades of Grey

The US dollar index is an unequally-weighted basket of six different currencies.  The biggest weighting is toward the Euro currency, which makes up 57.6% of the index’s value.  The rest of the currencies that make up the index are the Japanese yen (13.6%), British pound (11.9%), Canadian dollar (9.1%), Swedish krona (4.2%), and Swiss franc (3.6%).

You can short the US dollar index, of course, but you can also get more specific and bet on the long side of one single currency against the greenback.  There are several to choose from, but I will mention just a few of your choices here.

Since it has the most weighting against the US dollar index, the Euro currency might be a good instrument of choice for dollar bears.  It will run the closest to being a mirror image of the US dollar index.  More importantly, it has significantly more liquidity than the US dollar index does.  In the futures markets, the Euro currently has open interest of just over 451,000 contracts and the US dollar index has open interest of just over 84,000 contracts.  The bullish Euro currency ETF (FXE) has volume of just over 1,150,000 and the bearish US dollar ETF (UDN) has volume of just over 21,000.  Liquidity matters!

Although it only accounts for 13.6% of the US dollar index weighting, the Japanese yen is another currency worth consideration.  It’s a little less correlated to the US dollar index than the Euro currency is, but it’s still highly liquid and traditionally a great currency for trend followers.  In January the yen signaled a bullish trend change via the 20-month Moving Average, which has an admirable track record, and has stayed close to it since.  If you aren’t long the yen yet, there’s still time to hop on board that train.

Earlier in the post, I mentioned that the US dollar’s trend has a strong inverse correlation to commodities.  This also extends to commodity dollars like the Canadian dollar, Australian dollar, and New Zealand dollar.  These are the currencies of commodity-producing countries and are strongly linked to commodity price trends.  Therefore, a decline in the US dollar could be the rising tide that finally lifts these currencies from their multi-year slump.

Choose Your Weapon

All of the currencies can be traded in forex, of course. If you already have a forex broker and a platform you’re happy with, great.  You already know what to do, so just keep on keepin’ on.  But many currencies can also be traded via futures contracts or ETFs as well.  Make sure you think it through before jumping in.

I’m a bit biased because I started my trading career in the futures markets.  That being said, one of the things that I really like about currency futures contracts is that it offers tons of leverage (much more than you really need), but with regulations that they can’t seem to bother with in forex.

I recall a time when I had a stop order filled in forex on a Swedish Krona.  The slippage on the fill was bad enough, but I was really livid when I found out that some of the other banks I talked to didn’t even show that the price went low enough to trigger my stop in the first place!  When I complained to the bank desk I was trading at, they said, “Hey, we’re doing you a favor by even taking an order for a $7 million dollar position in the first place.  You can’t expect to get the same kind of fills as our institutional traders.”  That was the last time that I traded currencies in forex.  At least in the futures market, I know the price range is the same for everybody.

If you’re a smaller trader or new to currency trading, I suggest you steer away from forex and futures contracts for now and look at the ETFs.  You don’t get the same amount of leverage, but hey, you don’t need to mess around with high leverage when you’re new to trading or operating with a small stake.  Your goal should be to focus on following your trading process and preserving capital.

Once you have a few years of trading experience under your belt and your trading capital has grown, then you can proceed to…

Focus on following your trading process and preserving capital!

Perhaps you’ve heard the Zen saying that goes, “Before Enlightenment chop wood, carry water. After enlightenment chop wood, carry water.”

Well, maybe we should have a trader’s saying that goes, “Before Experience follow trade rules, manage risk. After Experience follow trade rules, manage risk.”

You will find that the successful traders don’t use nearly that much leverage, either.  Also, the pros don’t focus on how much money they can make; they focus on how much money they can lose.  Their time and energy is spent on monitoring their trading systems and managing risk, not trying to figure out how to turn a $10k account into $10 million in twelve months of day trading.

It’s a good possibility that the multi-year run higher in the US dollar has finally ended.  It’s time for traders to get loaded for bear.  Make sure you’ve chosen the right weapon (forex, futures, ETFs, options, etc.), you have enough ammo (risk size determines how many shots you can take), and then exercise patience (wait for the right setup and a trade signal).  Remember: A good hunter doesn’t chase; he waits.

 


More Articles by Jason Pearce:

Equities: US Against the World

Profiting From Failure: The Wash & Rinse Trade, Part II

Profiting From Failure: The Wash & Rinse Trade, Part I

How to Trade with Moving Averages, Part II

How to Trade with Moving Averages, Part I

Market Returns Do Not Equal Investment Returns with Leveraged ETFs

Is The Canadian Housing Market Bad for Canadian Banks?

2017: The Death Year for Stocks

Potential Bond Market Reversal Ahead

 

Jason Pearce

Jason Pearce

Jason Pearce is a 25+ year veteran of the futures markets. Since 1991, he has played the roles of retail broker and managing director of a brokerage firm, trader, market analyst, newsletter writer/editor and trading systems/algorithms developer. Jason is now actively managing money as an independent RIA.
Jason Pearce

Latest posts by Jason Pearce (see all)

Jason Pearce is a 25+ year veteran of the futures markets. Since 1991, he has played the roles of retail broker and managing director of a brokerage firm, trader, market analyst, newsletter writer/editor and trading systems/algorithms developer. Jason is now actively managing money as an independent RIA.

Please note: I reserve the right to delete comments that are offensive or off-topic.