The US dollar (USD) has been one of the most phenomenal winning streaks in recent memory, rising over 8% since the beginning of 2015 alone. The current rally in the USD is the fastest price increase in the currency in over 40 years.
However, an analysis of the USD’s valuations, together with short-term sentiment and technical indicators, provides reason to believe that the USD might have some downside potential in the coming weeks. In the following paragraphs I will explain these factors in more detail.
Everyone is long the US Dollar
Market positioning in USD is undeniably extreme, as the most recent CFTC Commitment of Traders data indicates that investors have record net-long positions (Figure 1). In comparison, the current net long-position is much larger than during the Financial Crisis of 2008 and the European Debt crisis of 2012.
Figure 1: CFTC Commitment of Traders non-commercial net-positions in US Dollar Index futures (Source: www.TimingCharts.com)
The extreme bullishness towards the USD makes the currency quite vulnerable to a small correction. The odds of a correction are further amplified by the fact that the fundamentals for the American currency have deteriorated drastically over the past months.
The US Dollar is quite expensive
A valuation model used by JP Morgan indicates that the USD is significantly overvalued (Figure 2). According to their calculations, the FED Funds rate needs to be around 3.5% by 2018 in order to justify current USD valuations. These valuations seem far-fetched as the rate-market is currently pricing in a FED Funds rate of only 2.25% in 2018. In order to close this gap the US Federal Reserve (FED) would have to signal an acceleration in the expected tightening cycle.
Figure 2: US Dollar Index versus predicted price according to valuation model (Source: JP Morgan)
However, the opposite seems to be the case, as last week’s Federal Open Market Committee (FOMC) policy statement was surprisingly dovish. The most significant surprise came from the sizable downward revisions of the FOMC’s interest rate expectations, the so-called “dot chart” (Figure 3).
Figure 3: Current FOMC projections for the Fed funds rate versus December 2014 (Source: JP Morgan)
In layman terms, this means that the FED will start raising interest rates later and at a slower pace than was projected in December 2014. As the USD is trading at such lavish valuations, last week’s dovish surprise from the FOMC is quite bearish for the US currency.
Furthermore, the first cracks are starting to appear in the USD’s technical condition.
The US Dollar Index is in a powerful long-term uptrend. That being said, odds of the USD correcting downward in the coming weeks have increased (Figure 4). We have seen some notable downward movements recently and the USD is currently trading under the short-term 20 day moving average. The MACD index shows a negative cross-over, indicating that momentum is currently moving towards the downside.
Figure 4: USD technical analysis as per March 24th
The current technical posturing together with the extreme bullishness and weak fundamentals give me reason to believe that the USD could trade somewhat lower in the coming weeks. My target for the US Dollar Index is the price area between 93-90, which corresponds with the position of the 100 and 200 day moving averages.
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Simon is the CEO and Editor-in-Chief of Foresight Investor. He has been following the markets passionately for over 7 years.