Forex Trading Library

Has the Dollar Reversed?

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Since the end of March, the dollar index has been trending downwards.

We can attribute a lot of this to increasing concerns about inflation, as the Biden Administration announced successive spending plans and the economy recovered.

At the start of May, it took another leg lower in response to the disappointing NFP payrolls. This suggested the Fed might be slower to raise rates.

But, broadly speaking, for the last couple of weeks, it has been trending sideways. And yesterday it even rose quite a bit before pairing off gains later in the session.

So, has the dollar touched bottom? Well, the answer might not lie in the US, but might have more to do with the situation in other countries.

How you measure is also important

The dollar index is calculated based on the major currencies with which it trades. But by far the biggest in that basket is the euro, representing 57.6% of the basket.

The closest runner-up is the JPY with just 13.6%, then the pound at 11.9%.

The three main driving factors of the dollar index are: inflation expectations, interest rates, and general instability in world markets. The greenback remains the world’s reserve currency, so it tends to default higher, all other factors being equal.

Getting a handle on where things are going

The eurozone is determinant in the trajectory of the dollar index (or its relative strength to other currencies), not just because of the size of its position.

Other currencies that are in the basket, such as the SEK, are either virtually pegged to the euro, or are highly influenced by it (GBP, CHF). So, where the dollar goes (and the commodities that are priced in dollars) depends a lot on the relationship with Europe.

The EU has taken a different approach to dealing with the pandemic, with notably different results. This includes the monetary front. While the US has expanded the monetary base by over $2.5T since the beginning of the pandemic, the EU has only by a little over €1.0T.

It’s inflation vs interest

Since there is a clear correlation between monetary base and inflation, we can expect the US to have a higher inflation rate going forward than Europe.

The US’ more advanced vaccination program sees the country recovering faster than Europe. And the US had higher economic growth than Europe prior to the pandemic.

All those factors suggest that the dollar will likely get weaker as long as the Fed keeps rates low. Investors who worry about the erosion of their wealth from inflation might find the European markets more attractive, supporting the euro.

But, with more sluggish growth in Europe compared to the US, it might mean the ECB can keep interest rates lower for a longer time than the Fed. That would suggest an overall weaker euro in the long term.

So, has the USD reached a bottom? The fundamentals generally don’t suggest it. Especially if we get a disappointment in the NFP numbers later today. Then we could see the dollar track lower as expectations of the Fed stepping in are pushed forward.

On the other hand, better jobs numbers might suggest the Fed will be satisfied the economy is on the right track sooner.

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