US dollar outlook: Eliminate market noise using this indicator on DXY directional risks

• US two-year note futures use fundamental and technical information to provide an instant assessment on directional risks for shorter-date US bond yields
• US bond yields are an important driver of US dollar movements
• Two-year note futures can be used to assess USD directional risks, providing a clean signal that eliminates noise

US dollars make the financial world go round 

The US dollar is a key pillar of financial markets in its role as the global reserve currency, making its performance important when it comes to how other assets classes fare.

Given its influence, traders devote much of their time attempting to assess which direction the big dollar will move, looking at fundamental and technicals, along with what central banks are saying. While there is absolutely nothing wrong with considering numerous factors, those who do so run the risk of missing important signals amidst abundant noise.

It’s easy to miss key market signals with so much noise

Just think of how many Federal Reserve views you hear each day, both from FOMC members and those who analyse them, this scribe included. And then add the raft of economic data that’s received, and the interpretation of that information. And then the headlines on top of that, most of which are designed to trigger curiosity but not necessarily convey the important message.

It’s endless. The more you see, read and hear, the greater the potential for information overload. As many experienced investors already know, sometimes the best way to avoid mistaking noise from signal is to simply cut out the noise.

US two-year Treasury note futures provide signal by compressing noise

When it comes to the outlook for the US dollar, you could do worse than watch US two-year Treasury note futures for guidance. As one of the most liquid contracts worldwide that combines fundamentals and technical views, it compresses huge amounts of information to provide an instant guide on where markets see directional risks for short-term US interest rates.

As you can see in the chart below, the rolling daily correlation of the US dollar index with two-year US bond yields over the past three months sits at 0.87, representing a strong positive relationship between the two instruments. Readings this high are not unusual over prolonged periods, underlining that short-end rate differentials are an important market driver for currency valuations.

How to use this key market indicator

Right now, my view is the US dollar is vulnerable to downside near-term. As discussed in a note earlier this week, with US economic data rolling over, traders who don’t need a second invitation to price in large-scale rate cuts could easily drag two-year yields lower, and the US dollar with it.

But it’s only a hunch. To test my view, I’m watching two-year note futures closely.

US two-year note futures test key level

Last Friday, they came close to what would have been an important bullish breakout, smashing through resistance at 101*24, the 50-day moving average and 200-day moving average before reversing hard into the close. Without looking at anything else, it tells you immediately that markets aren’t confident the trajectory for shorter-dated yields is lower near-term. And, accordingly, nor is my USD vulnerability thesis backed up the price action we’ve seen. Prices are weakening again, indicating higher yields.

Source: Refinitiv 

It’s hard to be bearish USD until this level gives way

Given the big reversal in shorter-dated US bonds, it should come as no surprise we also saw a meaningful reversal in the US dollar index which slid through support at 105 to briefly kiss the 50-day moving average before rebounding sharply. The subsequent price action has also been constructive, seeing the DXY push above 105.50, putting it on track to retest the 2024 highs.

But I’m not convinced the risk of dollar downside has reduced greatly despite the price action. The event calendar is quiet this week and it’s far too early for Fed speakers to pivot from the higher for longer rates message we’ve been hearing for months, providing the dollar some respite. But that may change next week with important macro events, headlined by US CPI.

If the spottiness in recent US economic data continues, keep a close eye on the price action in US two-year note futures. Because if they break definitively higher, it’s likely the US dollar will do the exact opposite.

Looking to short DXY, but not yet

I’m more interested in selling rallies than buying dips right now, but I’ll be using note futures to guide on how to proceed. Unless we see them revisit the lows struck last week, I’ll be looking to sell ahead of 160.50 with a stop above for protection.

Should US two-year note futures take break and close above the high struck last Friday, there’s every chance DXY could slide back towards 102.65 unless accompanied by a major risk-off episode.

-- Written by David Scutt

Follow David on Twitter @scutty