The US Dollar Index amid ‘inflation or…else’ mindset

Marius Paun | London, UK | Senior dealer | Wednesday, 12th February 2020

This week, we’re going to look at the US dollar value as a stand-alone currency which is best expressed by the US dollar index. It is a measure of the US dollar against a basket of its major trading partners’ associated currencies; the EU, Japan, the UK, Canada, Sweden and Switzerland. Nonetheless, its fate in the current climate, where deflation scares still trouble the US central bank, remains closely tied to the domestic interest rate.

In December last year, The US Federal Reserve decided to keep its benchmark cash rate unchanged at 1.75% during a meeting classed, by and large, as uneventful. And yet, Chair Jerome Powell signalled the Fed had no plan to hike rates any time soon saying he would ‘rather hang off until inflation moves significantly and also becomes persistent’. That comment, made at that moment, was taken by the markets as a recognition that Powell had joined former boss Alan Greenspan’s dovish path.

Fast forward and the US non-farm payrolls report for February posted some extraordinary job gains. Despite that, inflation does not look to be taking off and the Fed continues saying there is no need to worry about it.

Even more unusual, the Fed is considering changing the rules as to let inflation run above its 2% target, according to Financial Times. The policy of targeting 2% inflation began in 2012 and the shift would be a considerable change. It could signify that spurring inflation is becoming a top priority.

And that’s where the value of the US dollar (US dollar index) comes into play. A weaker dollar would spark higher commodity prices which in turn would also push inflation higher. So, finally, Powell might just try to give the US President Donald Trump what he has consistently asked for…a lower greenback.

One potential unknown that could derail the setup (at least on the short term) is a coronavirus. Demand for safe-haven assets (including the US dollar) is on the up since the outbreak last year and it is anybody’s guess when that will falter. However, although the Fed acknowledged the epidemic as ‘a serious issue’, they don’t seem to be too worried about its impact on US growth.

Another potential setback for a weaker dollar quest, one that might have a longer-lasting effect, could come from the ongoing strength of the US economy, positive surprises on sentiment surveys or robust employment growth. Together they show a clear head start for the US, versus the developed economies club, so investors might want to continue parking their cash into US dollars. On the other hand, markets will be well aware of the old saying ‘don’t fight the Fed’. This is possibly the reason why investors are still pricing in a rate cut for the second half of 2020.

Looking at the chart, in September 2019 we can see a double top developed around 99.3 marks which were followed by three months of a downward trend. Funny enough the slump in December coincides with Boris Johnson winning the UK elections. That means the relief rally for the pound sterling looked even better as the US dollar was on a decline regardless of the British elections’ outcome.

The recent bottom was reached on December 31st at 96.02. Since then the US dollar index has rallied back, touching 98.87 on Tuesday last seen in early October last year.

On the upside, if the 98.87 level will be breached, it will indicate that more buyers are coming back. If the momentum continues, the rally could extend to 99.3, the next upside target which will confirm the long-term trend is intact.

As shown this morning, at least for now, 98.87 has held. The inability to cross above it will signal the presence of increased selling pressure. Look for the next downside target first at 98.47, Monday’s low. It will be another sign of weakness if today the price closes below. Support just above 98.00 handles is next in line to be challenged.

Anyway, the moving averages are pointing sharply higher and the short-term one sits comfortably above the longer-term one, both pointing upwards.