Heading into this year there was a convincing case for a dollar rally. After all, the world’s reserve currency had fallen sharply against most of its major rivals in 2017 as the luster of the pro-dollar “Trump Trade” wore off and the realities of governing set in. As a result, speculative futures traders had flipped to a net short position of 7,000 contracts in the dollar index, according to the CFTC’s Commitment of Traders (COT) report at the start of this year, which is the most bearish positioning since mid-2014. In other words, expectations for any dollar-positive developments were extremely subdued as we entered 2018.
As any pole vaulter will tell you, it’s relatively easy to clear the bar when it’s set too low. In this case, dollar bulls have capitalized on the lopsided positioning and a continued run of solid economic data in the first half of the year to drive the U.S. dollar index up 7.5% from its February lows. The greenback has rallied by even more against currencies in which futures traders held heavy net long positions, such as the Canadian and Australian dollars (+8% and +9% off the February lows, respectively).
Unfortunately for U.S. dollar bulls, the strong positioning tailwind at the start of the year has now run its course. According to the COT report, futures traders have now shifted back to a net long position in the dollar index, to the tune of 35,000 contracts. This is the most bullish reading in more than a year and closer to the middle of the three-year range. With lopsided positioning no longer a catalyst for the greenback, traders are turning their attention back to the fundamentals.
The U.S. Federal Reserve is still poised to raise rates at least once more this year, with the potential for another two hikes by the end of the second quarter of 2019, but the outlook beyond that is murky. Last month, the Eurodollar interest rate curve for June 2020 inverted, signaling that traders believed the Fed was more likely to cut its benchmark interest rate than raise it in 2020.
As CNBC commentators remind us daily, the market is a discounting machine, meaning that the dollar is likely to peak well before the Fed switches to a more dovish outlook, whether that’s in the second half of 2019 or 2020. Indeed, the market’s skepticism over continued Fed rate hikes is the primary reason for the much-ballyhooed flattening of the U.S. yield curve.
In contrast, the European Central Bank (ECB) is likely to shift to a more hawkish posture during the next year. The ECB is planning on winding down its asset purchases by the end of this year, with a new rate hike cycle set to kick off in 2019, assuming everything goes to script (always a big assumption when looking out at future economic developments).
Sooner or later, forward-looking forex traders may start weighing the potential for the U.S./Eurozone interest rate spread to start tightening after spending the last three years growing wider. Of course in trading, being right but early on a thesis is the same thing as being wrong. Accordingly, readers will want to wait for a sign that the U.S. Dollar Index is resuming its long-term downtrend before turning bearish.
The first level of potential support to watch will be the trend line off the May low in the mid-94.00s, followed by the three-month low near 93.20. Alternatively, a convincing break above the one-year high in the mid-95.00s would show that strong bullish momentum is trumping any fundamental concerns and could open the door for a continuation higher toward 98.00 in time.