From the desk of Steven Strazza @Sstrazza and Ian Culley @IanCulley
Commodities and cyclical assets have remained resilient, defying headwinds from the US dollar for nearly a year.
But the US Dollar Index $DXY is sliding lower as evidence mounts in favor of further weakness…
Could those headwinds soon fade away?
Today, we’re going to highlight some critical developments and discuss what they mean for the US dollar, stocks, and commodities in the weeks and months ahead.
Let’s dive in!
First is a chart of the US Dollar Index $DXY:
Its inability to hold above the November 2021 highs screams "failed breakout!"
After undercutting these former highs on Monday, we saw some downside follow-through on Tuesday. Two data points supporting a bearish resolution are commitment of traders (COT) positioning and momentum.
In the middle pane, we’ve highlighted commercial hedgers holding a stretched net short position nearing three-year extremes (highlighted in red).
Commercial hedgers are the smart money and tend to be positioned at extremes at significant tops and bottoms… like they are now.
Another significant piece of information is waning momentum, indicated by the bearish divergence in the 14-day relative strength index (RSI). Not only is there a divergence, but momentum did not even reach overbought territory to confirm the new highs last week.
These momentum divergences often – but not always – accompany inflection points. This adds to our conviction of a potential failed breakout – especially in light of the current COT positioning.
The US Dollar Index isn’t the only area of the currency market testing critical levels while commercial positioning is extended.
The Australian dollar is in a similar situation. But instead of failing to hold above former resistance like the DXY, it’s reclaiming a key level of former support following a shakeout beneath the recent lows.
Here's a chart of the AUD/USD cross:
Not only are commercial hedgers holding a net long position nearing three-year extremes, they’re just shy of the all-time record long position set last fall.
Like the positioning profile in the DXY, an unwind in commercial longs in the Aussie would help ignite and sustain an AUD/USD rally.
But more important than anything else, we need to see this failed breakdown resolve higher – and it looks to be doing just that as of this writing.
What appeared to be a head-and-shoulders top is turning into a failed pattern. One of our favorite signals is when head-and-shoulders formations turn out not to be head-and-shoulders formations.
It looks like that’s what’s going on here in AUD. There's also a bullish momentum divergence in play.
If this pattern fails, it will be a powerful signal for the currency market – one that we have to imagine is taking place in an environment where the DXY is resolving lower.
And, if the failed breakout in DXY sticks and continues to catch lower, we’re going to see the euro rally:
Since the euro comprises more than half of the US Dollar Index, it’s essentially the inverse of the DXY chart. So it’s no surprise to see the euro failing to hold below its November lows while momentum diverges.
We should look to the euro for confirmation of the price action in the DXY. Any move in the DXY that does not coincide with a similar move in the opposite direction in the EUR/USD is suspect. It’s that simple.
Now, if all these failed moves are following through in the opposite direction, how do we think risk assets are performing?
For starters, they’re no longer dealing with the headwinds brought on by the USD rally. Instead, they’re probably enjoying a tailwind that's breathing life into a fresh leg higher.
If that head-and-shoulders pattern fails in the commodity-centric AUD/USD, the Aussie isn’t the only market on the rise. Emerging markets, copper, and commodities in general should also move higher.
A falling dollar greatly benefits global risk assets. And with equities coming under pressure, a weaker USD might be exactly what they need right now.
For now, we want to keep a close eye on the currency markets. The future direction of these charts will have broad implications, affecting both stocks and commodities.
