Diving Into The DXY Index

Ian Culley
March 5, 2021

From the desk of Steve Strazza @Sstrazza and Ian Culley @IanCulley.

The US Dollar is one of the most important pieces of the intermarket puzzle.

It affects all the major asset classes, and a rising dollar could impact the current market environment by creating a headwind for stocks and suppressing commodity-centric and cyclical areas of the market.

This could put pressure on our current market thesis as US Dollar strength has the potential to put a damper on the recent rally in risk assets.

In this post, we'll take a look at what's going on underneath the surface in the US Dollar Index by running through some of it's largest components.

We'll then weigh the evidence in front of us in an effort to determine a directional bias for King Dollar.

First things first, here's the US Dollar Index $DXY.

DXY is consolidating and trying to build a bottom within a primary downtrend. It just closed at an important level of former support turned resistance at the 2020 low, and 2021 high in the 91.60 to 91.75 area.

If we're above this level, we could see a significant counter-trend rally that puts pressure on other asset classes.

On the other hand, if we're below it there’s really no cause for concern and we'd anticipate further downside for the dollar.

With it looking like decision time for DXY, let's take a look at what the major crosses that make up the index are saying about where it's likely headed from here.

First up is the Euro, as it is by far the largest component of the DXY with a weighting of just under 60%.

EUR/USD is in a structural uptrend but has been struggling to break out of a continuation pattern as it chops around former resistance turned support at its 2020 highs. Momentum has been in a bullish regime for about a year now but has been lackluster so far in 2021.

From a tactical perspective, the trend remains higher for the Euro, but it needs to hold the 1.195 level that is currently being tested. Below there, and things can get dicey in the short-term.

Pay close attention to this one because in the case the EUR/USD does violate this level, we'd have to imagine it's happening in an environment where the Dollar Index is above 91.75 and squeezing higher.

Next up is the British Pound, another top component of the DXY with a weighting of 12%.

The Pound is in an even stronger uptrend than the Euro as it recently broke out of a multi-year base and is closing in on its highest level since its collapse following the historic 2016 Brexit vote.

Although, the currency has sold off in recent weeks and looks vulnerable in the near-term. A move back toward 1.374 appears likely, and if that doesn't hold... 1.344 is the next line of support.

This kind of corrective action could result in as much as a 3.5% move from current levels. Even though it would only be counter-trend in nature, this development would likely have a meaningful impact on the Dollar Index.

From a structural standpoint, as long as GBP/USD is above 1.344 the path of least resistance is higher. This is yet another major currency adding to the downward pressure on the Dollar index looking out over the long-term.

Lastly, we have the Canadian Dollar, which carries a weighting of almost 10%. CAD has a high correlation to commodity prices due to the country's high exposure to natural resources.

USD/CAD has been in a steady downtrend for almost a year now and has been in a bearish momentum regime since last summer. This makes sense as we've seen commodity-centric areas of the market like Energy and Metals catch a bid and trend higher over the same time.

The trend is definitely lower for USD/CAD across all timeframes. Although, with the cross recently breaking to its lowest level in 3 years, we still want to see it break its key 2017 lows around 1.20 before we give the all-clear for a structural trend reversal. Everything else we're seeing suggests this will eventually be the case.

Though to play devil's advocate, the recent momentum divergence could spark a failed breakdown if we get a decisive close above the 1.28 - 1.29 zone. Thus similar to the Pound and Euro, CAD has the potential to put upward pressure on the US Dollar Index in the near-term.

We just focused on some of the major constituents of the DXY and identified multiple levels that we'll use to either confirm our thesis on the current trend or give us a heads up that it might be changing.

Let's take a step back now and think about the chart setups for these three FX pairs.

While the primary trends are not in favor of the US Dollar, we could envision a scenario where each of these currencies experiences some mean-reversion action, thereby putting a near-term bid in DXY.

The levels we outlined above are designed to help gauge just how severe this counter-trend move is likely to be... if it even happens at all.

Although in line with our broader risk-on thesis, the weight of the evidence continues to suggest further weakness for the US Dollar over the long-term.

Let us know what you think!

Is the Dollar due for a bounce? If so, will it be enough to put any meaningful pressure on risk assets?

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Allstarcharts Team

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