Since the
Global Financial Crisis the US Federal Reserve has acted on an unprecedented
scale in its monetary policy. Central bank run programs like Quantitative Easing
and Operation Twist were utilized to artificially stimulate the US economy
after the Great Recession.
The objective
for monetary actions, like Fed-open market purchases of bonds, was to drive
interest rates lower as well as increase the amount of money available in the
economy. While well-intentioned in its design, the latter may have consequences
that are beginning to take effect in the value of the US Dollar (USD).
That is,
creating an excess of a currency in an economic system will eventually lead to
inflation and in extreme cases hyperinflation and currency devaluation. Presently,
we are experiencing an increase in rates of inflation throughout the US which
has signaled the Fed to begin a cycle of raising interest rates.
Accordingly,
increasing interest rates is intended to help quell the rate of inflation
growth that is driven by amplified economic activity. However, given the record
amount of debt issued during the recovery years and subsequent dollars
dispersed into the economy we must remain open to seeing unfamiliar territory
in asset classes such as currencies if inflation expands more rapidly or farther than anticipated.
Long-term Perspective
Looking at
the monthly chart of USD we can see that price has slipped below recent support
to levels not seen since 2014.
Leading up
to this price decline was a negative divergence in the USD’s monthly Relative
Strength Index (RSI) which I shared with clients throughout 2017. Negative
divergences form when an indicator, like RSI, makes a lower high while the
price makes a higher high. Typically, negative divergence foreshadows lower
prices to come. Underlying the divergence is a lack of price strength required
to drive an oscillating indicator, like RSI, to new highs that confirm the
price action. Ultimately, a lack of follow-through by a first derivative
indicator of price, like RSI, can provide a warning sign.
In addition
to the negative divergence, USD was unable to find buyers at the 92.00-93.00
level which previously stood as meaningful support. As a result, based on the
data over the past 10 years USD may not see significant buying activity
re-enter the market until around 87.00-87.50.
For the time
being, the trend remains down in USD over the long-term as implied by its price
action and its Moving Average Convergence Divergence (MACD). Additionally,
while there are no guarantees that an indicator like RSI will reach an
overbought or oversold level of 70 or 30, respectively, an RSI reading at 36.43
coupled with a strong MACD downtrend could imply that there is more room for
lower prices before reaching capitulation.
Intermediate-term Trend
On the
weekly chart there are several indications that the downtrend will continue.
For example,
USD continues to make lower lows and lower highs characteristic of a classic
downtrend. Support around 93.00 from 2016 was broken during the summer of 2017.
At the same time USD reached oversold levels on it weekly RSI indicating the
strength in the move downward was significant.
Over the
latter months of 2017 USD built a reactionary, counter-trend move back to 95.00
and mid-range on its weekly RSI. However, the recovery was short-lived and USD
resumed its decline taking out the lows from late 2017’s reversal point and
closing in new low territory in the process.
Additionally,
the weekly trend indicators confirm the price action. For instance, USD’s
weekly MACD displays a bearish cross-over to start 2018 which indicates that
the trend is down by this measure. Furthermore, USD’s weekly Average
Directional Movement (ADX) has resumed its trend higher after consolidating.
ADX is used to measure trend strength and a value over 25 is indicative of a
very strong trend. Considering that directional movement implies that a down
trend is in effect with -DI over +DI investors should keep their USD trades
positioned short for the time being.
Over the
coming weeks, the charts should be monitored for any positive divergence that
may develop any of the indicators referenced on the weekly chart. For example,
while price has already made new low the charts have yet to display a new low
in MACD or RSI. Accordingly, any higher low formed by these two indicators
could provide evidence that the price is reaching a point of reversal.
Short-term Trend
Zooming in
one order of magnitude shorter to the daily chart the story is much the same.
Since
breaking support at 91.50 USD has declined quickly reaching new lows.
Accompanying these levels is a very oversold reading on the daily RSI of 20.36.
Accordingly, the price is very extended in its decline as measured by this
reading. However, given the long-term downtrends in place USD’s ability to
continue to make lower lows confirmed by oversold readings on RSI are a sign of
strength for the down trend.
Otherwise,
positive divergence on the daily chart would begin to sow the seeds for
recovery from a longer-term perspective as changes in the short term need to
occur first in order to reverse a long-term trend. Much akin to how new seasonal
growth on a tree starts on the smallest limbs before changing the overall appearance
of the tree from its previous winter state.
Until we
begin to see signs of reversal on the daily chart, keeping your portfolio
aligned with the dominant down trends in place on higher time frames should allow for your P&L to benefit.
However, all
trends will reach an exhaustion point and a swift move down like the one on
USD’s daily chart may begin to show signs of reversal in the coming days to
weeks. With a lot of open space below before the next support level on the charts,
it may take some time before bids start coming in to support the USD. Once
these signs of reversal start to reveal themselves in the price action short
positions should be scaled down at that point.
Key Takeaways
The excess
credit generation and securitization of structured products leading into the
Great Recession left the world with an extraordinary amount of debt in the
global economy. During the subsequent years of recovery that debt was absorbed
by Central Banks around the world and monetary stimulus programs were enacted
to revive sovereign economies. However, as a trade off, through stimulus
programs the private sector was flooded with each country’s respective currency
at an historic level.
The ongoing
conundrum for Central Bank policymakers will be how to quell inflation from
picking up too quickly through slowing economic growth by using its primary
tool of raising interest rates. However, if the past is any indication of the
future then the Fed will likely be slow to raise rates in a manner that will meaningfully stop the economy from overheating too quickly.
When economic
activity picks up there is typically a commensurate increase in the rate of
inflation. As a result, when inflation ticks up there will be a decline in the
purchasing power of the respective currency.
Currently,
we may be witnessing the beginning stages of market participants re-evaluating
the prospects of a strong USD considering our point in the economic cycle with interest
rates rising from historic lows and inflation beginning to grow while there is more
money in the system that has yet to be utilized. That is, the unprecedented
amount of monetary stimulus may cause currencies like USD to print levels that
have not been reached for many years.
Remaining
open to probable outcomes based on objective, unbiased data that is determined
by the market should allow for clients and investors to stay one step ahead of
future developments.
As always,
please feel free to contact me with any questions or comments. Thanks for reading.
John
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