In March 2020, the dollar index rose to its highest level in eighteen years since 2002. The move to a high of 103.96 came during a risk-off period and a flight to quality during the early days of the spread of the global pandemic to Europe and the United States. Since then, the dollar declined, reaching its latest low on September 1 at 91.750 on the nearby December futures contract. In under six months, the world’s reserve currency fell by 11.7%.
The dollar index futures contract trades on the Intercontinental Exchange. It measures the value of the Us currency against other leading reserve currencies. Since central banks worldwide hold dollars and euros as the primary foreign exchange instruments, the dollar index has a 57.6% exposure to the European currency. Governments, central banks, and monetary authorities worldwide manage the currency markets to stabilize the global financial system. The 11.7% move in under half a year was a significant decline in the value of the dollar over a short period. In September, the index bounced from its low and was over the 94 level on September 29, but the US currency’s overall trend remains lower. The Invesco DB Us Dollar Index Bearish Fund (UDN) moves higher when the value of the dollar index declines. The UUP product operates inversely, as it moves higher when the dollar appreciates against the euro and other world reserve currencies.
A rebound in the dollar index in September
The December dollar index futures contract reached a low of 91.750 on September 1. Throughout September, the index made a series of higher lows and higher highs as the dollar recovered.
As the daily chart highlights, the dollar index reached a high of 94.795 on September 25, a 3.3% rebound from the low. On the final day of September, it was just below the 94 level. The total number of open long and short positions has been flatlining on either side of the 30,000-contract level. Price momentum and relative strength indicators turned lower from overbought conditions but were above neutral readings. Daily historical volatility at 5.65% has edged higher since mid-September when it fell to a low of 3.80%. The dollar moved higher as volatility returned to markets in September.
A flight to quality during a speedbump in markets
The dollar index rose as the stock market experienced a mild correction in September.
As the chart of the December E-Mini S&P 500 futures contract illustrates, the drop from a record high of 3,576.25 on September 3 to a low of 3198 on September 24 corresponded with the rise in the dollar index. In September, many markets experienced corrections. Crude oil fell from over $40 per barrel to below $37. Gold and silver corrected lower, and other high-flying markets hit speedbumps.
The upcoming US election, rising coronavirus cases, and concerns over another risk-off period prompted the dollar to recover as market participants sought safe assets. The dollar’s role as the world’s reserve currency acted as a magnet in September and lifted the greenback. However, the bearish trend since March remains intact despite the flight to quality.
The weekly chart of the US dollar index shows that a move above the 98 level is necessary to reverse the bearish trend in the greenback that began six months ago.
The inflationary Fed and the US government will continue to increase the money supply
In May, the US Treasury borrowed $3 trillion to fund the stimulus, which blew away the previous record from 2008 when it borrowed $530 billion. While political wrangling before the November 3 election prevents leaders in Washington DC from rolling out another package that will require the Treasury to borrow another couple of trillion dollars, the economy needs more stimulus, which is likely before the end of this year.
The US Federal Reserve continues to hold the Fed Funds rate at zero percent. At the September FOMC meeting, they told markets to expect short-term rates to remain at the historical low until 2023. The Fed also shifted its inflation policy. While 2% was previously a line in the sane for inflation, the central bank moved to an average rather than a target of 2%. Some of the FOMC members said they are prepared to accept inflation readings of 2.25% to 2.50% before acting to increase short-term rates. The Fed will continue to use quantitative easing and liquidity to provide stimulus during and after the global pandemic. The bottom line is that monetary and fiscal stimulus is at unprecedented levels, and they increase the money supply. The willingness to accept higher inflationary pressures that eat away at the dollar’s purchasing power is bearish for the greenback.
While the dollar could attract more buying if risk-off conditions return to markets, it would only increase and accelerate monetary and fiscal stimulus, which eventually erodes the US currency’s value.
The election could create lots of uncertainty
The first debate between President Trump and his challenger, former vice president Joe Biden took place on September 29. The debate was more like a UFC cage fight than a gentlemanly discussion of the issues facing the United States. There was not much meat on the bone when it comes to specific policy intentions. However, the debate highlighted the opposing visions for the future of the US. The Presidential election, together with contests that will determine the majorities in the House of Representatives and the Senate, will determine the fate of tax, energy, social, and a host of other policy issues. Therefore, markets across all asset classes could become highly volatile over the coming weeks. Markets dislike uncertainty, and the most contentious contest in memory is not a prescription for stability. The challenger continues to hold the lead in polls, but so did Hillary Clinton in 2016. Moreover, a close election could mean declaring a winner could take weeks or months, which would only add to the uncertainty. Simultaneously, the US and world now face a second wave of coronavirus with rising case numbers.
The bottom line is that market volatility will continue, the potential for risk-off conditions will rise, and monetary and fiscal stimulus will continue to flood the global financial system. While the dollar may continue to work higher, selling the greenback on a scale-up basis is likely to be the best approach for 2021.
Selling the rally by buying UDN
The most direct route for a risk position in the dollar index is via the over-the-counter foreign exchange market or the futures and futures options that trade on the Intercontinental Exchange. For those looking to participate in the volatility in the dollar index without venturing into the OTC or futures arenas, the Invesco DB Us Dollar Index Bearish Fund (UDN) and its bullish counterpart (NYSEARCA:UUP) provide an alternative. The fund summary for UDN states:
Source: Yahoo Finance
UDN has net assets of $52.62 million, trades an average of 166,745 shares each day, and charges a 0.75% expense ratio. UUP is the bullish product that moves higher when the dollar index rallies.
The dollar index fell from 103.96 in March to a low of 91.75 on September 1, a decline of 11.74%.
Over the same period, UDN climbed from $18.96 to $21.37 per share or 12.71%. UDN does an excellent job replicating the price action in the dollar index. I continue to favor selling the dollar on a scale-up basis during the current rebound.
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