Why fundamental support for the dollar is starting to look thin

The dollar’s recovery after a pretty torrid 2017 has been a much anticipated trend for the latter part of 2017, so how much longer will we have to wait for this rally to materialise? Since reaching a low on Sept 8^th, the dollar index has rallied some 3%, however, this reversal has been fairly messy and sporadic so far and unlike a typical uptrend.

Below we look at 5 factors that could impact the next trend in the dollar, and to conclude we give our best case scenario for where the buck may go in the short term.

• The Fed: the Fed’s hawkishness is undoubtedly a support for the dollar right now. The US central bank has agreed to start shrinking its balance sheet, and there is currently a 70% chance of a rate hike in December, up from 34% just a month ago. Thus, if Fed speak in the next couple of weeks continues in this hawkish vein we could see further pricing in of a December rate hike, which should be dollar supportive. (Dollar positive)
• Yields: The sharp move higher in US Treasury yields last week, they rose 30 basis points, the largest weekly rise all year, should also be a good support for the dollar. However, yields need to break above 2.4% and march towards 2.6% for them to remain dollar supportive. (Dollar neutral)
• Inflation: this has been a sticking point for the Fed as inflation has remained weak throughout most of this year, however, the increase in breakeven rates, a gauge of US inflation expectations, is encouraging for dollar bulls. The 5-year 5-year forward breakeven rate is currently at 1.95%, which is below the 2% average of the year so far, but well above the 1.8% low from June. This suggests that slowly, but surely, inflation expectations are rising. (Dollar neutral)
• Politics: President Trump introduced his much anticipated tax reform programme last week, which has helped the dollar to recover. The slash to corporation taxes, the confirmation of the repatriation rate for corporate profits stashed overseas and the dumping of the double taxation rate for overseas’ profits were all welcomed by dollar bulls. While this has been dollar positive so far, there are reasons to be sceptical that this will benefit the dollar in the long term. Firstly, there are no guarantees that this will pass Congress and see the light of day, secondly, if the tax reforms do get passed they are likely to lead to an increase in the already large US budget deficit, which should be dollar negative. Thus, we don’t see tax reform as being a major driver of the stronger dollar in the longer term. (Dollar neutral)
• Technical: Sometimes it is not the fundamentals that drive a currency but the technical picture. When you analyse the fundamental drivers of the dollar they start to look a little shaky, and there are far more factors that are dollar neutral rather than dollar positive. Thus, the technical factors may come into play. The dollar index is approaching a key support level, as you can see in the chart below, 93.70 – 94.20 is a key resistance zone, and if we get a weekly break above this level then we could see the bulls start to change their mind. (Dollar positive, if resistance is broken)

As you can see, sometimes the technical factors are worth a closer look than well-worn fundamental ones, and this appears to be the case for the dollar right now. There is a slew of economic data released this week, including the crucial NFP data on Friday. This data is likely to determine whether or not the dollar index ends the week above or below this critical resistance level. If the dollar index can convincingly break above it then a move back towards 95.30 – the 38.2% of the March to Sept downtrend could be on the cards, ahead of the 96.00 highs from July. 

Chart 1: 

Source: City Index and Bloomberg