I wrote about the push and pull of catalysts on the U.S. dollar index after a breakout above resistance at its 200-day moving average (DMA). Although the dollar usually sustains breaks above or below its 200DMA, this time the dollar quickly proceeded to sell off. DXY broke down below its 200DMA and then its 50DMA before retesting the lows of 2021. With a consolidation of the price action favoring an upward path of least resistance, I see signs of a bottoming in the U.S. dollar (UUP, UDN).

The U.S. dollar index (DXY) is rebounding from a test of its 2021 lows. Source: TradingView

Supportive Monetary Policy from the ECB

Last week’s commentary from the European Central Bank (ECB) combined with events in the U.S. bond market further convince me that the path of least resistance is shifting upward for the U.S. dollar.

The euro (FXE) consumes a little over 50% of the U.S. dollar index. As a result, recent selling in the euro helped drive the dollar’s bottoming pattern. The latest euro drop came in the wake of the ECB’s latest statement on monetary policy. The ECB sounds like it is more concerned with potential tightening in financial markets than with inflationary pressures. As a result, the ECB is leaning on looser and more accommodative monetary policy. From the introductory statement:

“Inflation has picked up over recent months, largely on account of base effects, transitory factors and an increase in energy prices. It is expected to rise further in the second half of the year, before declining as temporary factors fade out. Our new staff projections point to a gradual increase in underlying inflation pressures throughout the projection horizon, although the pressures remain subdued in the context of still significant economic slack that will only be absorbed gradually over the projection horizon. Headline inflation is expected to remain below our aim over the projection horizon.”

The notion of significant slack in the EU’s economy creates a strong contrast to the bullishness and confidence of the Federal Reserve in the U.S. economy. That divergence alone is sufficient to keep me short EUR/USD. The ECB’s concerns over monetary tightening from financial markets provides more support for my trading bias.

“…market interest rates have increased further. While partly reflecting improved economic prospects, a sustained rise in market rates could translate into a tightening of wider financing conditions that are relevant for the entire economy. Such a tightening would be premature and would pose a risk to the ongoing economic recovery and the outlook for inflation.”

The ECB explained the dangers of the monetary tightening in the Q&A portion of the press conference:

“…we see a little bit of tightening – very, very moderate though – but there is a potential that what we observed on the market interest rates actually could pass through or is at risk of passing through to the financing conditions that are applicable to the corporate sector in particular.”

These concerns support the ECB’s decision to deepen its commitment to still looser monetary policy.

“Based on a joint assessment of financing conditions and the inflation outlook, the Governing Council expects net purchases under the PEPP over the coming quarter to continue to be conducted at a significantly higher pace than during the first months of the year.”

Finally, the ECB reminded financial markets that it will act against an overheating euro. With EUR/USD recently stopping just short of its highs since the start of the pandemic, I think the message below suggests the ECB will fight against renewed upward momentum in the euro.

“We will also continue to monitor developments in the exchange rate with regard to their possible implications for the medium-term inflation outlook. We stand ready to adjust all of our instruments, as appropriate, to ensure that inflation moves towards our aim in a sustained manner, in line with our commitment to symmetry.”

A Contrary U.S. Bond Market

I also like going long the U.S. dollar as a contrary trade parallel with the surprising decline in bond yields in the wake of an inflation reading that appeared to come in hot. If concerns over inflation pressures recede in the U.S., I can only imagine fresh disinflationary fears could subsequently infect assessments of the relatively weaker eurozone economy.

The iShares 20+ Year Treasury Bond (TLT) broke out from its recent trading range. Source: TradingView

The Trade

Despite my bias to go long the U.S. dollar, I am not yet prepared to abandon my bullish bias for commodity friendly currencies like the Canadian dollar (FXC). Accordingly, I am still fading rallies in USD/CAD even as I stick to a short on EUR/USD. My short USD/CAD also provides a small hedge on broadly based U.S. dollar weakness (FXE).

Be careful out there!

Full disclosure: short EUR/USD, short USD/CAD