The Dollar Breaks But It Is Not Broken

The dollar's decline accelerated and broadened last week.  It convincingly broke out of its recent ranges.  Tactically, we did not expect the sustained break ahead of the December 10 ECB meeting, where the central bank that does not pre-commit pre-committed to easing policy. 

The recent string of economic data suggests that while the US activity has moderated, the recovery continues, Japan and Europe maybe experiencing a new contraction.  

Strategically, we have been arguing that the third big dollar rally since the end of Bretton Woods is over.   We began the year, noting that the policy mix was less supportive. At the same time, the exchange rate was overvalued against all the major currencies, and the interest rate differentials were moving against it.  The onset of the pandemic was disruptive for the capital markets, and the dollar rallied on safe-haven and unwinding of funding positions.  However, as governments and central banks responded forcefully, what we think is the underlying trend, re-emerged. Listening to clients and other market participants, it struck us that the framing being used to understand the dollar decline was a return of the twin deficit problem. 

The twin deficits refer to the fact that the US runs both large budget and current account deficits.  The eurozone, Japan, and China have budget deficits but current account surpluses. In order to finance the twin deficit, the US has to have interest rate differentials (often supported by growth differentials). When the differentials are not sufficient, the dollar acts like a shock absorber and shoulders some of the adjustment by depreciating.   

Here is how we see the current technical condition.

Dollar Index:  Last week, like the previous two, the Dollar Index managed to rise in one session.  It has fallen for four of the past five weeks.  Over that span, it has depreciated by about 3.8% and visited levels now seen since April 2018.  The MACD is near three-month lows, and the Slow Stochastic is flatlining in its trough in oversold territory.  It has finished the past four sessions below its lower Bollinger Band (~90.75).  The next significant technical area is around 90.00.  The four-year low set in February 2018 was near 88,25.  

Euro:  The euro broke through the top of its four-month trading range near $1.20 and raced up to almost $1.2180 before some consolidation ahead of the weekend.  It was unable to make new session highs after the disappointing US jobs report, indicative perhaps of the stretched momentum indicators. After breaking above the upper Bollinger Band, the euro has ironically been finding support near it (~$1.2135).  The 2018 high was around $1.2555, and ahead of that, various technical levels are cited between $1.22 and $1.24.  The downside risk emanates from the ECB.  A push back into the $1.2025-$1.2075 area would help make the rally appear and feel orderly while not jeopardizing the upside breakout (FXE).  

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Read more by Marc on his site Marc to Market.

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