The high water mark for the U.S. Dollar Index ($DXY) during the current economic cycle is 100.52, recorded December 2, 2015. In the five months since this peak, the USD shed 8.6 points, sliding down to a support shelf in the low-90s (illustrated below) that consistently arrested declines in 2015. Most recently, the greenback reacted to this threshold by bouncing 1.33 points (so far) off Monday’s low. Our work anticipates further appreciation of the dollar versus most major currencies in weeks and months to come.
In addition to the rebound off of a vetted support level, we cite indications from our medium-term momentum model as validation for the idea that the dollar should gain ground in weeks to come. Per the lower pane of the previous chart, our measure of (weekly) price-based momentum is expected to bottom next Friday the 13th, and then to improve for the next several months. The momentum reversal we are looking for should coincide with a $DXY rally.
Dollar strengthening might correspond with market participants pricing in a higher probability of a Fed rate hike in June. Per the next chart, Fed Funds futures currently imply only about a 10% chance of a 25 bps increase in the target Fed Funds rate when the FOMC next convenes on June 14-15, however, economists are much more open to the possibility that the Fed moves further toward monetary policy normalization next month.
To this point, and in contrast to the positioning of Fed Funds futures investors, an early-April Wall Street Journal article found that 75% of surveyed economists expected a hike in June.
Additionally, in the wake of the April FOMC meeting, (non-voting) Federal Reserve Presidents, Dennis Lockhart and John Williams, have both suggested the market is underestimating the potential for action at the upcoming meeting (see here for details).
Our final chart shows the path of the Citigroup U.S. Economic Surprise Index over the last couple of years, and illustrates that while macro data continues to disappoint (the current level is well below zero), incoming data of late is better than was the case at the the February low, and the February readings are markedly better than what was evident at the March/May 2015 bottoms. Thus, macro data has improved over the last year or so as well as over the last few months, suggesting the economy may be gaining some traction.
Data such as the American Chemistry Council’s Chemical Activity Barometer (CAB), which has been demonstrated to lead Industrial Production, and rail traffic, also purported to contain information regarding the economy at large, have likewise demonstrated improvement in recent months, corroborating the expectation for a continued rebound in macro activity.
If we are correct and the circumstances described above coalesce to propel the dollar higher in weeks to come, global equity investors should consider hedging FX exposure, especially to the Euro, as this currency makes up about 58% of $DXY. The Yen is the second-largest constituent in the index, albeit a distant second, with about a 14% weight (the Canadian Dollar, Swedish Krona and Swiss Franc comprise the remaining 28% or so of the U.S. Dollar Index).
Also, investors should reconsider exposure to gold, as monthly changes in the price of the continuous gold futures contract have demonstrated a statistically significant negative correlation with monthly changes in the US Dollar Index (r=-0.42 for the 239 month period spanning June 1996 to April 2016). True to the historical linkage, the yellow metal appears to have peaked as the dollar bottomed.