From the desk of Steven Strazza @Sstrazza and Ian Culley @IanCulley
All eyes have been on the US dollar and interest rates in recent weeks.
Last week, we saw a timely kick save from the bond market as the 30-year reclaimed its summer lows. Whether the latest rebound in rates will hold is yet to be seen as the 10 and 30 are currently chopping sideways just above our risk levels. We’re watching the long end of the curve closely to see how yields react at these critical levels.
But what about the US dollar?
When we analyze the US Dollar Index $DXY, it’s hard to be bearish, as price is consolidating in a tight continuation pattern following a base breakout and swift leg higher last month. As usual, the direction in which the DXY resolves will have broad market implications and will affect risk assets around the globe.
We know you’re probably tired of hearing it, but this is another big week for markets -- especially the dollar!
As investors brace themselves for the Federal Open Market Committee announcement tomorrow, the stage is set for some volatility from the buck.
So let’s dig in and look at a couple of charts that will help prepare us for the next major move in forex markets.
First, we have a chart of the US Dollar Index $DXY:
For the past few weeks, volatility in the index has been contracting as price coils in the form of a pennant. These types of short-duration continuation patterns often take shape halfway to the target and tend to resolve in the direction of the underlying trend. And that’s exactly what appears to be going on with DXY right now.
But with momentum in a bullish regime and DXY coiling in a tight pennant, we want to be ready to take advantage of the next leg higher.
We want to be long DXY on an upside resolution with a tactical target of 97.70 and a 2-4 month target back toward the 2020 highs of 103.
And if the US Dollar Index is going to resolve higher, we have to imagine that the EUR/USD cross is coming under further pressure.
Like DXY, the EUR/USD chart is also coiling in a tight pennant right now, but there's one major difference...
This one is a bearish continuation pattern, as it's occurring in the context of a downtrend, not an uptrend.
The EUR/USD might as well be an inverted chart of the DXY since it comprises more than half of the index. So, while we anticipate a resolution higher from the bullish pennant in the DXY, we’re looking for further downside action out of the EUR/USD pair.
Seeing the euro resolve lower is some of the best confirmation we could see for a resolution higher in the dollar.
Any meaningful upside move in the dollar should be accompanied by a similar move in the opposite direction for the euro. It would be a huge red flag if we fail to see confirming price action from the largest component of the index, so we're watching both of these charts closely here.
The bear pennant in EUR/USD offers a great trading opportunity as this pattern has formed at a key level of interest. We want to trade against the 61.8% retracement level around 1.1295 and sell weakness below this level, with a downside target near the 2020 lows around 1.0650.
To be clear, we can only be short below that key retracement level. Risk is definitely not in our favor if price reverses back above it, and we want to be on high alert for a sharp move in the opposite direction in the event these patterns fail.
Now that we’ve discussed these short-term continuation patterns, let’s talk about what these potential resolutions and further dollar strength could mean for the broader market.
For starters, international equities are probably catching lower. The cyclical/value sectors are also most likely coming under pressure if the dollar rips here. As for commodities, they're already struggling and are likely to struggle even more if the dollar makes another leg higher.
While it's true that risk assets have been impacted very little by the recent rally in the dollar, in no way does a stronger dollar help stocks and commodities. Could they continue higher? Of course. But how long this resiliency can last is one of the main questions we’re asking ourselves right now.
On the other hand, in the case these continuation patterns fail, it could put a much-needed bid back into cyclical stocks and commodities. A pattern failure and swift move lower in the DXY would be incredibly bullish for risk assets and could be exactly what they need right now, as many of these uptrends are on the ropes.
While we think this is the lower-probability outcome, we always have to keep an open mind and remain prepared for whatever the market serves us.
We should have some answers in the coming days.
We’ll be sure to keep you updated regardless of the direction in which these critical markets resolve.
