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U.S. Dollar Index Analysis: Significant retracement! Dollar struggles to sustain its uptrend?
Lucia Han
2021-06-25 862

Abstract: In recent days, the U.S. dollar index has bounced back violently, while other non-U.S. currencies have been in turmoil after the Federal Reserve unexpectedly sent a hawkish signal. But there are two very different views of the dollar rally. The dollar was supported by the belief among many investors that the Federal Reserve's tapering of its bond-buying program would be inevitable in response to rising inflation risks. However, some investors refuted upon it, saying that the dollar rebound may not last long as the Federal Reserve only released the expectation of tapering quantitative easing, but did not start to act. On the one hand, the U.S. dollar will be under moderate downward pressure in the long run, considering improved risk sentiment thanks to the re-opening of the economy and extensive vaccination. On the other hand, the uncertainty created by the Federal Reserve's debate on the extension of "temporary" inflation will be key to the dollar's price in the near term.

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Volatility in currency markets intensified after the unexpected hawkish stance of the Federal Reserve (Fed). At the recent Federal Open Market Committee (FOMC) meeting, Fed Chair Jerome Powell seemed pleasantly surprised by the contribution that accelerated vaccination has made to the U.S. economy. For the first time, the Fed signaled that it would begin to talk about tightening quantitative easing (QE), breaking from its dovish stance. Although Mr. Powell later reiterated that high inflation was seen as temporary and played down the possibility of an immediate rate hike, financial markets were once again thrown into turmoil by the sudden shift in the Fed’s stance. After the meeting, the dollar regained support on the upside, with the U.S. dollar index (DXY) briefly breaching 92 and hitting its best performance in nearly 10 weeks. As the dollar strengthened, other non-US currencies duly fell. What is the outlook for the U.S. dollar? What are the investment opportunities in non-US currencies?

Fed's attitude toward raising interest rates

The Fed's previously released dot-plot, used to chart policymakers' forecasts for future interest rates, shows that a majority of policymakers expect at least two rate increases by the end of 2023, and more than a third forecast to start raising rates by the end of next year, as shown below:


Source from: US Federal Reserve Projection

On top of that, the Fed's outlook for inflation increased further. On the one hand, after the U.S. economy reopened and consumer demand surged, supply bottlenecks and other constraints pushed future inflation higher than previously thought. On the other hand, despite the gradual improvement in the job market, millions of people were still out of work, whilst companies' hiring difficulties remained a drag on the balance of supply and demand. 

Not only that, the Fed bank governors’ attitudes towards the tightening of QE were mixed. John Williams, president of the New York Fed, dismissed the recent surge in inflation as temporary and said the current QE should not be changed amid uncertainty about the prospects for economic recovery. Dallas Fed Bank Governor Robert Kaplan preferred to start reducing bond purchases sooner rather than later. James Bullard, president of the Fed Bank of St. Louis, said the Fed's plan to scale back its bond purchases appeared to be getting closer. As a result, the Fed's interpretation of the inflation outlook will likely continue to be key in shaping its policy and will further lead to more dollar volatility.

Outlook for U.S. dollar index

While expectations of at least two Fed rate hikes by 2023 had supported a strong dollar rally, Fed Chair Jerome Powell played down inflation concerns in subsequent congressional testimony, saying that inflation is temporary and price increases, although being higher than expected currently, could fall back. After the meeting, the DXY retreated from its highs. Going forward, U.S. economic and employment data may influence Fed officials' stance on the QE. At the same time, the dollar could be in for a wild ride if the Fed sends a very different signal.

By technical analysis, bearish views on the dollar became the dominant theme in the market as inflation fears mounted and U.S. President Joe Biden proposed massive government spending. As a result, the DXY fell below 89.5 at one point, close to its previous support of 89.1, which was also its lowest level in nearly three years. Then, the dollar rallied strongly after a slew of stronger-than-expected economic data and sharply rising prices prompted the Fed to shift to a hawkish policy. However, the DXY briefly retreated by 0.8% from a multi-week high of 92.386 as the market digested the Fed's change of stance and the Fed remained downplaying higher inflation for now, as shown below:


Source from: Mitrade

In addition, the DXY's 20-day and 50-day moving averages were intersecting and forming a "golden cross" that suggests the technical pattern may still support a higher dollar. If fundamentals remain positive for the currency, investors should pay attention to the 93 resistance level.

What about other non-US currencies?

EUR/USD: The Fed's hawkish tone could reverse the uptrend in EUR/USD. For all the inflation fears in the U.S., the picture looks very different in the European region. As a result, the ECB will maintain a super high rate of asset purchases to support further economic recovery, which is somewhat hurting the euro. However, the gradual recovery in Europe on back of the accelerated vaccination and effective pandemic prevention & control offset the negative effect of the central bank's continued QE on the euro.

In terms of technical analysis, the euro fell 3.3% against the dollar to 1.1847 from this month's high of 1.2254, giving up most of its gains since April, as shown below:


Source from: Mitrade

EUR/USD was currently below the 20-day, 50-day and 100-day moving averages, with the 20-day and 50-day moving averages crossing downwards, indicating a clear bearish trend. Meanwhile, the Fed's hawkish stance also kept euro/dollar under pressure.

GBP/USD: With the reopening of businesses, the UK economy has grown by 7% this year, outpacing the U.S. and EU paces. Although the UK announced a four-week extension to the full economic reopening, its impact is likely to be only quarterly. On the contrary, the BoE is likely to tighten its QE and sterling may regain its upward momentum as the economic growth continues to exceed the central bank's expectations.


Source from: Mitrade

By technical analysis, GBP/USD had been trading sideways for nearly a month before falling sharply by 2.8% in recent days. However, GBP/USD rebounded gradually before the BoE meeting, and it broke the 100-day moving average and approached the 50-day moving average. Even so, the GBP/USD weakened again caused by BoE's unexpected dovish tone. In the short term, the bulls may lack confidence amid market volatility.

AUD/USD: The RBA is likely to maintain its dovish comments as the economy, despite its rapid recovery, remains constrained by inflation pressures and wage growth. The Australian dollar fell as commodity prices slipped sharply on the back of the Fed's change of stance, as shown below:


Source from: Mitrade

From a technical perspective, AUD/USD fell by 3.8% to 0.74771 from this month's high of 0.77753, below the 200-day moving average. The currency pair then recovered slowly as the dollar retreated, but the Australian dollar seemed to lack confidence in further gains in the short term.


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