5 charts: US dollar index a key consideration for forex traders

A clean read on USD movement is the US dollar index (USDX), which currently suggests a neutral USD position as price holds in a horizontal channel between 101 and 98.8. Traders, it seems, are waiting for conviction to break the USDX out of this channel.

Markets are currently focussed on the idea of negative interest rates in the US. Could this be the catalyst for a move above 101.0 resistance or below 98.8 support? Fed Chair Powell will speak tomorrow and the big question is: will he push back against negative rates speculation?

Daily chart: USDX is trading in a horizontal channel between 108.8 and 101.0. Chart source data: Metaquotes MT5.

The USDX has been moving sideways in this channel since the beginning of April, carving out strong resistance at the 101 handle and support at 98.8. As lockdowns begin to ease across the world, the position on the USDX remains fairly neutral until we see a break outside of the channel on a daily closing basis.

There is immediate support at the 50-day EMA (purple), which acted as daily support last week Tuesday and Friday. The 14-day RSI sits right in the middle of the band at 49.82, a neutral position.

The USDX continued its run towards 101 resistance yesterday as the Treasury yield curve steepened, a USD positive, and the Atlanta Fed’s Rafael Botsic talked against a negative Fed funds rate, calling it a weak policy tool. The move lower late last week came as markets started to price negative rates in the US by January 2021. Fed Chair Jerome Powell has previously indicated he does not see negative interest rates as an appropriate policy tool for the US, however rates markets expressed last week that the Fed may be left with no choice but to take rates negative as conventional monetary policy tools reach limits.

Markets will hear from Powell on Wednesday this week at 9am EDT (11pm AEST), at a virtual Peterson Institute for International Economics (PIIE) event from Washington DC. He is scheduled to discuss current economic issues but traders will be tuning in to see if he reinforces his stance against negative interest rates.

The USDX

The US dollar index is a great way to analyse relative US dollar strength. The index is measured against a basket of six currencies, each with a different weighting: EUR (57.6%), JPY (13.6%), GBP (11.9%), CAD (9.1%), SEK (4.2%), and CHF (3.6%). The USDX is a neat trade because in effect you can take an accumulative view of six currencies against the USD rather than just one.

Sentiment in USDX can help understand popular forex pairs movement in these currencies and vice versa. Let’s consider the three currencies with the heaviest weightings here: that’s EURUSD, USDJPY, and GBPUSD.

EURUSD

The euro has by far the heaviest weighting on the US dollar index, comprising almost 60% of the basket. So moves in the euro have the biggest impact on the USDX. In fact, compare it to the USDX and you’ll see very similar patterns on higher-timeframe charts.

4-hr chart: EURUSD has been trading in a horizontal channel between 1.0990 and 1.0770. Trend support from the March lows looks set to strengthen support. A break below here would be a powerful signal. Chart source data: Metaquotes MT5.

Similar to the USDX, EURUSD is trading sideways in a horizontal channel: between 1.0990 and 1.0770. In daily closing terms, a break above 1.0990 resistance should pave way towards 1.1120, whereas a break below 1.0770 support should pave way towards 1.0640. Also watch support trend from the March lows thought, which will strengthen support for euro downside in the near-term. If this level breaks, it’s a powerful sign of further euro weakness.

The fundamental outlook supports euro weakness for the euro with an increasingly divided European Union. Ideological differences between the fiscally conservative north and the more profligate south have resurfaced, as Italy’s calls for economic support are resisted. Then last week German courts ruled against the ECB’s QE program in its current form (PEPP excluded). The euro finds strength in unity across the bloc: division will be a heavy weight on the shared currency.

Markets have little reason to hold euros right now. As the euro falls, it will cause considerable upward pressure on the US dollar index, encouraging another test of that 101 handle and a possible break higher.

USDJPY

The Japanese yen (JPY) has the next largest weighting in the USDX basket at 13.6%, however it’s considerably smaller than the euro’s 57.6% weighting.

Daily chart: USDJPY closed above a descending channel in yesterday’s session on a strong USD bid. 108.0 is the next level to test. Chart source data: Metaquotes MT5.

USDJPY has shown increased sensitivity to US Treasury yields, weakening significantly yesterday on a strong US dollar bid after quietly depreciating in a descending channel since the beginning of April. USD strength saw a daily close just below the 50-day EMA (purple). Bulls will be eager to run this further to the 108 handle, further upward pressure on the USDX.

However that descending channel since April suggests a gentle yet consistent JPY bid. Considering adverse economic conditions and the uncertainty around easy Fed monetary policy, the JPY should receive a solid safe haven bid in the medium-term. The 106 handle shaped up as strong support last week, the level JPY bulls would need to see a daily close below for conviction of a strong move lower.

GBPUSD

The British pound (GBP) is being sold off again after a quick bid higher last week on a Bank of England (BoE) decision. GBP has an 11.9% weighting on the USDX and is similarly sitting in the middle of a horizontal channel waiting, approaching another test of the 1.2250 handle.

Daily chart: Downward pressure on GBPUSD looks ready to test the bottom of the horizontal channel at 1.2550. Chart source data: Metaquotes MT5.

GBPUSD bounced off the bottom of the channel on Thursday after the Bank of England’s policy decision was less dovish than expected. The central bank held rates at a record low 0.1% and maintained its bond-buying target, and GBP traded higher while the USDX fell.

GBP weakness was back in play yesterday though on a strong US dollar bid. Also key to mention is the BoE’s sobering comment that Britain could face its biggest economic slump in more than 300 years. Then consider the 200-day MA (black line) closely coincides with the top of the horizontal channel, and there’s a strong ceiling if upside were to persist. It’s an uninspiring outlook, and a daily close below the 1.2550 handle would pave the way for a new round of GBP weakness.

Together, GBP and EUR comprise 69.5% of the US dollar index basket. If both currencies continue to sell-off, that’s considerable upside for the king dollar.

Purchasing power parity

For a longer term picture, an idea is to consider relative FX valuation. It’s a subjective concept, and one of many factors influencing price, but a common model to consider is that of purchasing power parity (PPP). Economists would suggest that in the long run, currencies should revert to an equal PPP.

Purchasing power parity model measured in USD against the CHF, NZD, AUD, GBP, EUR, DKK, CAD, JPY, NOK, and SEK. CHF and NZD are slightly overvalued in USD terms, whereas JPY, NOK, and SEK are considerably undervalued in USD terms. Source: Bloomberg.

Right now, markets are focussed on the pandemic, lockdowns, and economic fallout, all of which will dominate in the short to medium term. The overall picture in the PPP chart is an overvalued USD, however most of the over/under valuations here are negligible. That said, the Japanese yen (JPY) and Swedish krona (SEK) stand out as significantly undervalued components of the USDX basket currencies. Together the pair comprise 17.8% of the basket, which would be decent downward pressure on the USD if they were to mean-revert towards PPP, something more likely to happen in the medium to long term than the short-term.