US Dollar Poised To Go Higher But Why?

This description characterizes DXY’s trading action in the 1980s into the mid-1990s with the selling avalanche acting eventually as a springboard higher with a similar dynamic setting up now. When potential pattern repetition of this nature plays out in one marketplace, it increases the odds of success the next time around and, in this case, it strengthens our opinion that the U.S. dollar index may climb toward 120 over the medium/long-term.

Interestingly, these bullish DXY chart technicals are very similar to those discussed around the VIX last week that make a case for a potential “super spike” higher as suggested by the Thomson Reuters chart below.

As can be seen in this long-term chart of the VIX to the left, its previous two Falling Wedges into bottoming formations have pushed this Volatility Index significantly higher with the current duo suggesting the VIX may climb to some level between 48 and 90 if not higher.

We think this is interesting because it may shed light on why the U.S. dollar index is poised to climb higher with two fundamental possibilities standing out to us at this time.

The first and more optimistic reason to think that the U.S. dollar index may climb significantly higher is the same as what likely caused its rally into 2001 and that was a strong U.S. economy. GDP growth was consistently between 4.0% and 6.5% according to data from multpl.com, the velocity of money was at a record high according to data from the Federal Reserve Bank of St. Louis and unemployment low according to the Bureau of Labor Statistics.

At this time, U.S. economic data is mixed at best with lumpy GDP growth and the velocity of money at record lows, but there is little question that the employment picture is improving nicely.

Should GDP growth smooth out and the velocity of money rise to match what is shaping the jobs data, it may be just such a constructive macro context that could continue to support the U.S. dollar index higher.

Providing support for the idea that this sort of an economic recovery is underway are the U.S. equity markets with the broad based S&P 500 climbing more than 200% over the last nearly six years and conceivably on an improving corporate profit outlook that should help shore up the macro economic data. It is difficult to believe that the U.S. equity indices will hold most of those gains unless on a noticeably improving economy.

But this leads to the second and less constructive point around why the U.S. dollar index may climb higher and one that ties into the VIX’s chart technicals along with the idea that perhaps the U.S. equity indices may fail to hold the bulk of those bull market gains.

Specifically, the U.S. dollar index is viewed as one of the most conservative and true “safe-haven” assets available to investors, and thus is bid up in times of market tumult and volatility.

This dynamic shows fairly well in a shared chart of the SPDR Barclays High Yield Bond ETF (JNK)  and the U.S. dollar index through and after the financial crisis according to data offered in the Thomson Reuters chart below.

It is clear that as riskier junk bonds sold off in 2008 into 2009 again in 2011 and to a small degree last year, DXY rallied and we believe it is reasonable to think that some of the risk money went into safe-haven dollars backed by the full faith and credit of the Unitied States government.

What may make the present moment interesting is to see whether the JNK sell-off continues and to what degree. Should it reverse, then the potential “flight to safety” scenario being described here probably will unwind.

On the otherhand, should the correction in JNK continue, past trading history in 2008 into 2009 suggests the U.S. dollar index may climb higher as investors seek relative safety and liquidity.

We admit that this argument is not perfect, but we think the cross-over made between DXY and JNK during the last financial crisis too significant to ignore the idea that something similar – even if less extreme – may be underway again.

It is this scenario that is supported by the VIX’s bullish chart technicals as well considering that the S&P 500 would very likely sell-off severely on any sort of “super spike” higher and one that could be consistent with high-yield bonds selling off.

Overall, then, it seems quite probable to us that the U.S. dollar index will continue to climb higher and it will be interesting with time to see why.

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