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Dollar Builds Towards Breakout: But Which Way?

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Dollar Builds Towards Breakout: But Which Way?
super dollar

This summer's strong rally in the dollar has figured into the discussion of nearly every economic subject, from commodities to corporate earnings. As the first interest rate hike in nine years by the Fed looms ever-closer, the dollar has been coiling in a 6-point range. It's due for a breakout--but in which direction?

Galloping Greenback

The current dollar rally began in August 2014, and by some accounts is the third-largest dollar rally in the last forty years. The trade-weighted value of the greenback is 37% higher than the last big low hit in May 2011. On March 13, 2015, the DXY dollar index broke 100 points for the first time since April 2003.

DXY-5year BarChart.com

Warning: Wedge Forming Ahead

However, since that March high, the dollar has been coiling in the mid-to-high 90s region on the DXY chart. This action has formed a wedge pattern (seen below). The problem with analyzing the current data for the dollar is that the markets are being distorted over uncertainty regarding the timing of the first Fed rate hike.

BarChart.com BarChart.com

July's Federal Reserve Open Market Committee meeting encouraged many forex traders to predict a September rate hike, which would spark another leg upward for the greenback. Others view such calls are something of a self-fulfilling prophecy, and believe that the first rate hike is already "baked in" to the dollar price.

A related question is whether the markets have been anticipating a rate hike for so long, that we might see a "buy the rumor/sell the fact" selloff that would push the dollar through the bottom of the wedge and into a reversal.

While the normal rules may or may not apply in this topsy-turvy QE-inundated world,  looking back at the reaction of the dollar to previous Fed rate hikes may be useful.  The last three times the Fed began a series of raising interest rates were in February 1994, June 1999, and June 2004. In the six to nine months before the first rate hike each time, the dollar gained an average of 8.6%. The rate of increase in the DXY weakened after the first rate hike.

Since the first of this year, the dollar has gained 7.6%. Past history would infer that it doesn't have much higher to go before late September. However, no major central bank has increased interest rates before in an environment where every other central bank was keeping interest rates at zero and engaged in pumping money into the system. Uncharted waters, indeed.

 Who's the Cart, and Who's the Horse?

Adding to the uncertainty is this question: Is the Fed driving the dollar, or is the dollar driving the Fed? While the answer may seem obvious at first glance, consider this:

  • A too-strong dollar hurts the profits of major corporations. From the fourth quarter of 2014 through the first quarter of 2015, overseas corporate receipts declined 5.6% simply due to the strength of the dollar.
  • Since commodities are traded internationally denominated in dollars, a stronger dollar means lower commodity and energy prices. Not only does this hurt emerging market and exporting countries, it suppresses inflation in the U.S. An anemic inflation rate has been a worry of the Fed, when deciding when to raise rates.
  • A decline in corporate profits and commodity prices has led to layoffs and decreased capital expenditures. This affects the unemployment rate, another key metric that the Fed uses when determining interest rate policy.

So, an overly-strong dollar could actually delay an interest rate hike by the Fed. That impending interest rate hike is a big factor in the strength of the dollar, which could be caught in a feedback loop.

On the other hand, a delay of even one month by the Fed in raising rates past the assumed start date of September could cause a knee-jerk reaction downwards in the dollar. In fact, it may take only one press conference by a senior Fed official to send the dollar market shooting off in one direction or the other.

The V-Word

All of this points to uncertainty and volatility. We haven't even touched on external events that could affect the dollar, such as a "hard landing" in China, or an unraveling of the Eurosystem due to the Greek debt crisis. These external events could shock the dollar out of its wedge pattern (either upwards or downwards) long before the September Fed meeting. If there is any certainty at all, it's that the dollar is going to move one way or the other in the near future.

About the Author

Everett Millman

Steven Cochran

Precious Metals Market Analyst
BS University of South Florida (2002)

A published writer, Steven's coverage of precious metals goes beyond the daily news to explain how ancillary factors affect the market.

Steven specializes in market analysis with an emphasis on stocks, corporate bonds, and government debt. He writes a monthly review of the precious metals markets for SurvivalBlog.com.

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