Dollar Hollar: An Introduction To Trading The Dollar Index

Welcome traders to this new weekly report on all things U.S Dollar Index related. In our weekly report we will take a look a the fundamental issues affecting the USD along with the key chart technicals in play and most importantly we will look at trading locations for the week ahead.

First Things First

This week I would like to begin with a quick overview of the U.S Dollar Index, its history and why it is so important to the global FX trade.

As its name suggests the U.S Dollar Index is an index representative of the U.S Dollar and its relative value to a basket of international currencies. The U.S Dollar Index was introduced in 1973 and came into existence as the Bretton Woods System of financial management was dismantled.

The Bretton Woods system was essentially a post World War II protocol for international commercial exchange between the United States, Canada and Western Europe. The essence of the Bretton Woods system was an agreement by its constituents to anchor their currencies to gold, in the hope of creating a level playing field for the purposes of international exchange. The Bretton Woods system ran into insurmountable problems when the United States terminated the agreement to convert US Dollars to gold which was essentially the US’s rejection of the gold standard for international monetary exchange. This unilateral action by the United States heralded the development of the modern day foreign exchange markets with the US dollar becoming the reserve currency to the world and many countries launching a free floating currency.

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Since its inception in 1973 the US Dollar Index has only been adjusted once, this was in 1999 when the Euro was introduced, the index currently constitutes

Euro (EUR) 57.6% weighting

Japanese Yen (JPY) 13.6% weighting

Pound Sterling (GBP) 11.9% weighting

Canadian Dollar (CAD) 9.1% weighting

Swedish Krona (SEK) 4.2% weighting

Swiss Franc (CHF) 3.6% weight

The US Dollar Index trades as a mean in relation to the basket, the setting for the mean is 100.00, during its life time the Index has traded as high as 164.72 ( a 64.72% appreciation) in February 1985 and as low as 70.69 ( a 29.31% deprecation) in March 2008

Now we have an understanding of what the US Dollar Index is and how it came into existence lets take a closer look a the economic fundamentals driving the price action before we jump into a technical review of the charts.

Buy The Rumor… Sell the Fact

Dollar bulls have been in the driving seat since last summer as traders and investors have been eagerly anticipating a rise in the US interest rates, which traders believe will make the US Dollar a more appealing home for capital flows, as higher rates will deliver an attractive yield against developed and emerging market currencies. As is often the case the market operates as a future pricing mechanism and as such the market has bid the Dollar up on the potential of the Fed move.

Nearly a decade since the last move

It has been nearly ten years since the last rate tightening cycle took place in the U.S. Since 2009 the Fed has implemented emergency monetary policy due to the exceptional tightening of  credit conditions that took hold of the markets during the financial crisis. Market participants have been positioning for the the first rate move since the summer of last year. Players perceive that when the first hike occurs it will denote a distinct policy divergence between the US and its major trading partners, most of whom are embarking on monetary easing policies at present.

First in first out

As the Fed were the first major bank to act post the financial crisis, market watchers and economists believe that the US domestic economy has been the primary beneficiary from its actions as witnessed in robust domestic employment data and a healthy uptick in asset prices. Obviously the recent correction in equities has aroused concern among Fed members but most see the recent correction as transitory and since last weeks FOMC three members have come out in support of a rate move in Q4 2016.

First move not always the right one

When the Fed makes its first move the most prevalent market response will be to buy USD, the challenge will be in estimating the glide path and duration for US rates, which is likely to be slow and steady at best. This muted rates move may act as an impediment to prolonged USD bullishness. It is noteworthy that in three of the last four US rate tightening moves the USD has caught an initial bid leading up to and just after the initial move but has then sold off. Participants may become skeptical about the impact of a stronger USD on domestic earnings an issue that the FOMC is certainly cognizant of.

Global macro a drag down the road

Downside risk to the USD upside potential may also be seen when we consider the global macro pulse. Although the Fed will benefit from being the primary mover in acting to off set the financial crisis, they may also suffer from the second mover advantage syndrome. It is conceivable that European and Japanese economies could begin to reap the rewards of growth orientated domestic monetary polices coupled with weaker currencies making them attractive investment zones . As the upside advantage of muted US rate hikes likely has little impact on a swelling current account deficit, the removal of foreign investment flows may act as a significant drag on USD attractiveness.

In the Charts

Ok, so now we have a solid sense of the fundamental drivers behind the US Dollar trade lets jump in to the charts and see what the technical set ups are suggesting for the probable path of price

Big Picture

Looking a the monthly scale there are a couple of key observations we can make

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Take-a ways from the monthly chart

  • price has breached major trend line resistance form the all time highs (Bullish)
  • price is consolidating above horizontal and trend line support (bullish)

Medium Term

Now we have established some key structure on the Monthly scale lets zoom in to the daily scale to get a sense of the structure medium term

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Essentially we can see a more detailed expression of the consolidation we witnessed on the monthly scale. The daily scale continues to support a bullish bias while we rotate within broader bullish flag pattern.

Trading Takeaways

  1. From a trading perspective we have some interesting bullish confluent factors on the Monthly scale breaching some key trend-line and structure resistance
  2. On the daily scale we have confirmation from the Psychology indicator
  3. Keeping things nice and simple we should look for an upside breach of the descending trend line and throwback to retest the broken resistance as support for a move higher from this bullish consolidation phase

We have moved in some broad strokes this week covering the USD Index history and make up, we have taken a look at the broader fundamental drivers and have dipped into the technical perspective on the larger scale charts.

Next week we will get a little more granular looking at the more near term fundamental drivers and technical patterns that may provide some intra/multi day trading opportunities.