In a December 18, 2023, Barchart article, I wrote:
The U.S., Europe, the United Kingdom, Japan, Canada, Sweden, and Switzerland are allies. Therefore, the U.S. dollar index measures the U.S. foreign exchange instrument against currencies with aligned geopolitical interests. The dollar index reflects an allied bloc, making it a mirage in the worldwide financial system. The Fed is a leading central bank, and many other allied central banks coordinate monetary policy over time. Therefore, U.S. dollar index component countries will likely follow U.S. rates lower over the coming months. Coordinated monetary policy lowers currency volatility, the goal for the allied central banks.
The Fed left the short-term Fed Funds Rate unchanged at the December 13 FOMC meeting. However, the surprise was the shift in tone and forecasts for cutting interest rates in 2024. The statement and Chairman Powell’s press conference had a significantly dovish tone. Stock, bond, and commodity markets roared after the Fed’s Greenspan-esque surprise.
The dollar index was 102.55 on December 18 and moved higher to just under 104 on February 23. Interest rates and the latest inflationary data pushed the index slightly higher over the past two months.
January inflation data comes in hot
On February 13, the January consumer price index report showed that inflation remains stubborn and the Fed’s hopes of a return to its 2% target could be challenging. The January CPI rose by 0.3%, but core CPI, excluding food and energy, was 0.4% higher because of a 0.6% increase in shelter costs. Stocks, bonds, and interest-rate sensitive commodity prices declined after the inflationary data, likely delaying the Fed’s first rate until later in 2024.
On Friday, February 16, the producer price index provided a similar picture, rising more than expected, as inflation remains at a level where the central bank is not likely to increase or decrease short-term interest rates.
The dollar index rallied but has not run away on the upside
Interest rate differentials are the most significant factor for the path of one reserve currency against the others. High U.S. interest rates and nagging inflationary data have put upward pressure on the U.S. dollar index since the end of 2023, when the market expected lower interest rates in 2024.
As the chart highlights, the dollar index rallied 4.3% from 100.62 on December 28 to 104.98 on February 14 and was not far below the high at over 103.95 on February 23. In 2023, the index traded from a low of 99.58 to 107.35. The index was above the midpoint of the 2023 trading range on February 23. While the index rallied in 2024, it has yet to make its way to a test of the 2023 peak.
The Fed’s 2% target could be a challenge
The latest January consumer and producer price index data validates the Fed’s cautious approach. At the last FOMC meeting, the U.S. central bank told markets it needed more evidence that inflation was approaching its 2% target.
The tidal wave of central bank liquidity and tsunami of government stimulus during the 2020 global pandemic planted inflationary seeds. While tight monetary policy since March 2022 has caused inflation to decline, the 2% target could be unrealistic in the current environment.
Market disappointment could cause the economy to decline
Many market participants believe the Fed will cut the Fed Funds Rate and slow its quantitative tightening program, taking pressure off long-term rates later this year. Over the past weeks, the stock market has rallied to record highs, but the recent price action in the bond market could mean that equities could run out of upside steam.
The March U.S. 30-year Treasury bond futures reached a 107-03 low on October 23, 2023, when it put in a bullish key reversal pattern on the daily chart. The long bond futures took off on the upside, reaching a 125-30 high on December 27 on optimism that rates would decline in 2024. However, the inflation data has poured cold water on the bond market rally, sending long bonds to 118-14 in mid-February.
Thirty-year fixed-rate conventional mortgages rose to over 8% in late 2023 and below 7% in early 2024 but were back to over 7% in late February. Meanwhile, higher interest rates for longer than the market had anticipated could weigh on the stock market as attractive fixed-income returns cause capital to flow from equities to bonds. Higher rates also weigh on housing, commodity, and other asset prices.
The events that could push the dollar above resistance or below support over the coming weeks and months
The Fed watches CPI and PPI data, but its favorite index is the PCE, which comes out at the end of February. If the PCE shows the same nagging inflation level, expect the central bank to continue to pause.
Meanwhile, the most significant factor facing bonds, the U.S. dollar index, and markets across all asset classes is the turbulent geopolitical landscape and the contentious U.S. election. The U.S. dollar and U.S. bond market have been historical havens for capital during uncertain times. Therefore, any escalation of the wars in Ukraine and the Middle East, or any new conflicts, could cause bonds and the dollar index to rally as investors and traders seek shelter. Unforeseen events could lead to dollar index volatility as the November U.S. election approaches.
In late February 2024, support for the dollar index is 99.58, with resistance at 107.35. If the index were to eclipse either of these levels, the broader technical targets are the January 2021 89.20 low and the September 2022 114.78 high.
The most direct route for a risk position in the dollar index is the futures and futures options on the Intercontinental Exchange. The Invesco DB U.S. Dollar Index Bullish Fund (UUP) is an unleveraged ETF that moves higher and lower with the dollar index. The Invesco DB U.S. Dollar Index Bearish Fund (UDN) moves higher when the dollar index falls and lower when it rallies. UUP and UDN provide an alternative to the futures arena for market participants seeking long or short exposure to the U.S. dollar index.
The odds favor an inside year in the U.S. dollar index, but many factors could ignite surprises that defy the odds and send the dollar index higher or lower over the coming months. In late February 2024, the geopolitical landscape and higher for longer U.S. interest rates favor the upside, but the election could send the currency index either way later this year.
On the date of publication, Andrew Hecht did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
