US dollar index, USD/CHF look squeezy if traders pare aggressive Fed rate cut bets

• Markets price over 120 basis points of rate cuts from the Fed this year
• Fed unlikely to signal rate cuts of this magnitude this week
• DXY, USD/CHF no longer being heavily influenced by US rates markets
• US dollar may strengthen if Fed rate cut bets are pared

Overview

Everyone seems to want to dunk on the US dollar, largely because markets are pricing over 120 basis points of rate cuts from the Fed by the end of the year. Given how much it’s on the nose, I’m looking for potential squeeze candidates in the FX universe should the Fed disappoint on increasingly dovish expectations. USD/CHF and US dollar index (DXY) are two that should be on the radar for traders.

Fed pricing looks too aggressive

As covered in an earlier note, market pricing for Fed rate cuts over the next few meetings has ballooned in recent days thanks to a string of dovish messages from suspected Fed mouthpieces working in the media. A 50 basis point rate cut is now favoured in September with a strong probability of two supersized rate cuts arriving before the end of the year.

Each to their own, but I just don’t see the Fed going down that path unless there’s evidence the US is entering recession, pointing to the potential its revised rate cut profile may not be anywhere near as aggressive as markets expect. If that is the case, we could see a violent upward adjustment at the front of the US yield curve, potentially dragging the US dollar along for the ride. 

DXY, USD/CHF stop following US yields lower

The next chart looks at the rolling 20-day correlation between a variety of US interest rate markets with USD/JPY in the left-hand pane, the DXY in the middle pane, along with USD/CHF in the right pane.

From to bottom, the variables presented are 2024 Fed rate cut pricing, year ahead Fed rate cut pricing, US two year yields, US five-year yields, US 10-year yields and US 30-year yields.

Based on strength of correlations, USD/JPY is a prime squeeze candidate with score of around 0.9 or higher across all variables. If you want to read up specifically about USD/JPY, I’d encourage you to look at the note I put out earlier detailing key events and levels.

However, while USD/JPY remains heavily influenced by US interest rate markets, the DXY and USD/CHF are not, a big departure from what was seen over much of July and August. What were very strong positive correlations have turned to mush.

Now, this could mean if we see rate cut bets pared this week, neither DXY nor USD/CHF will care. However, my reading of the abrupt weakening is that rates markets may have gone too far in what’s been priced, with FX traders unwilling to add to dollar shorts after what’s already been a significant move.

I suspect that if and when rates markets strip out some of the Fed easing that's been priced, DXY and USD/CHF could squeeze higher, potentially aggressively.

DXY not threatening cyclical lows

DXY has yet to print fresh lows despite the dovish tilt in Fed pricing, remaining in the relative narrow range between 101.768 and 100.52 it’s been stuck in since the middle of August. With RSI (14) trending higher and MACD doing the same, bearish momentum is waning, pointing to shifting directional risks for price.

If we were to see a clean break above 101.768, it could likely bring a retest of the downtrend running from early July. And if that level were breached, the 50-day moving average and resistance at 103.65 may come into play. On the downside, a break and close below 100.52 may see DXY retest 99.60, the double bottom hit in July last year.

USD/CHF: momentum turning?

Turning to USD/CHF, the rejection at the intersection of downtrend and horizontal resistance last week has seen the pair move back to the centre of its recent range between .85414 and .8402. However, with bullish divergence between RSI (14) and price, and with MACD continuing to trend higher, bearish momentum continues to weaken, pointing to an increased risk that price may soon follow. The long downside wicks on the daily candles over the past week further strengthen this view.

If the price were able to break the downtrend, .85414, .86171, the 50-day moving average and .87287 are topside levels of note. If the price were to decline and close below .8402, .8333 would be eyed by bears.

-- Written by David Scutt

Follow David on Twitter @scutty