Four Horsemen of Dollar Index

Central banks around the world are highly active. Some, like in Switzerland and Denmark, are working overtime to prevent their respective currencies appreciate too much. Some, like in emerging markets – India, Russia, Ukraine etc. – are fighting to prevent their currencies not depreciate a lot. Then there are others, like in Japan, U.S.A. and EU, who are trying to revitalize or continue to prop-up their respective economies through unconventional measures aka Quantitative Easing. So it is time to take a look at the technical picture.

The 30,000 View or The Monthly Timeframe

Dollar is the reserve currency of the world and it has a major impact on emerging market currencies and on developed market currencies. The tradeable dollar index – there are two – consists of six major currencies, euro, yen, British pound, Canadian dollar, Swiss franc and Swedish krona. The futures for this index trade on InterContinental Exchange (ICE). The other dollar index is the trade-weighted one maintained by the Federal Reserve. Its basket contains currencies from most trading partners of the U.S.A. For this analysis we will take a look at the dollar index traded on ICE.

Dollar is in a long-term down trend – since 1980s. In between it has staged some sharp rallies. Once, from 1995-to-2001, it almost reached 80s levels. But, for most of the time it has remained close to or below the linear regression line represented by the red downtrend line in the above chart. The two outer bounds are one standard deviation lines.

Only once, from early 2000 to last 2002, did the index stay above the one-standard deviation. It is again reaching that level. The index is in a uptrend since May 2014. This level is also close to the 50% Fibonacci retracement, at 96.17, of the long decline from 2001 to 2008.

The third resistance point is the four-month congestion area formed between October 1998 and January 1999, point X in the chart. The fourth resistance point is formed by the Fibonacci extension of the previous rally, from May 2011 to July 2012. The rally is shown by point A & B on the chart and the extension is from point C. The 1,618 Fibonacci extension is at 95.51.

The chart shows just a significant resistance zone for the dollar index. What it does not tell is whether the index will turn back at this resistance or not. The resistance level could be strong enough to rebuff the advance or the momentum could be strong enough to overcome the resistance. That is why we need to continue to monitor the prices action.

If dollar index breaks through this level then the next resistance is near 102, at the Fibonacci retracement level of 61.8%; Fibonacci extension of 2.382; and the resistance formed by the highs of August 1998. If the resistance holds then the downward move could find a support at the previous resistance at 89 – high made in March 2009 and July 2010.

Whatever You Do, Don’t Act So Fast

Our first horseman is euro – the biggest component of dollar index.

The euro constitutes 57.6% of dollar index, hence its chart mirrors dollar in reverse quite closely, with few variations. Euro has been in a uptrend on monthly timeframe (Prior to euro’s creation, the chart uses the five European currencies – German mark, French franc, Italian lira, Dutch guilder, and Belgium franc – that were part of the index) with moves opposite of dollar.

The recent move of euro – since May 2014 – is on the down side. As of now it is breaching the lower bound of one standard-deviation. This coincides with the support at the 61.8% Fibonacci retracement of the rally from November 2000 low to July 2008 high.

The current level is also at or just below the support levels created by the lows made in December 2005 (point X on chart), July 2010 (point Y) and August 2012 (point B). The fourth support point is made by the 1.00 Fibonacci extension of the decline from 2011 high (point A) to 2012 high (point B) from the point C.

Unlike, the strength of dollar index’s resistance zone, euro’s support zone seems to be more suspect. It has fallen by almost 300 PIPs below the lowest support made in 2005 at 1.1662. It has also not fully reached the 1.00 Fibonacci extension at 1.0958.

If euro breaks this support then the next significant support is near 103, which is formed by the low of made in 1997 (point Z) and 1.272 Fibonacci extension. A bounce off this level will find resistance immediate above at the previous support levels at 1.18 and 1.20.

Yen, Not To Be Left Behind

The second horseman is Japanese yen, which comprises 13.6% of the dollar index. It is also forming interesting chart-pattern on monthly time frame, a long-term down turn, which means that the yen is appreciating as it is the denominator in this pair.

The recent move of the price – since September 2012 –  is up, which means that yen is depreciating.The current level is at the upper-bound of the one standard deviation. It coincides with the 61.8% Fibonacci retracement of the decline from high made in 1998 to the low made in 2012.

This level is also at some significant resistance levels. One is the lows reached in 1987 and 1987 – point V on the charts. Other levels are trading range formed in 2002 and 2003 at point Z; high made in January 2006 at point X; and the high made in July 2007 at point Y.

A break above this resistance level will take the pair to the next resistance zone formed by the 78.6% Fibonacci retracement and the 2002 high of 135 (point P). If the pair fails to clear this resistance and falls down then it may find support at near 105 or point U in the chart.

The Third Horseman – Pound Sterling

The third significant constituent of the dollar basket, at 11.9%, is the British pound. Its chart pattern on monthly time frame is most interesting.

Pound is mostly in a trading range – since 1981 – which means that its impact on dollar on the longer timeframe is neutral. Within this long-term trading rage, pound is also making a smaller horizontal channel (L1 and L2) since bottoming in 2009. The current move, from July 2014, has taken the cable to the lower limit of this channel.

The current price is also at the 1.00 Fibonacci extension of the decline from May 2011 high (point A) to July 2013 low (point B) from point C.

Pound’s price action is more biased toward staying within the horizontal channel formed by L1 and L2 than breaking out of it. If it does not break out, then its impact on dollar will be minimal, rather it will be reacting in response or sympathy to moves in other major currencies versus dollar (see next section). If pound breaks below the current level then it may find support at the 2009 lows near 1.40.

Fourth Horseman – The Central Banks

Since the 2008 financial crisis, the major central banks – The Federal Reserve in the U.S.A, Bank of England in UK, European Central Bank in Euro Zone, and Bank of Japan in Japan – have employed a variety of quantitative easing programs. As a St. Louis Fed states in its paper,

The programs initially attempted to alleviate financial market distress, but this purpose soon broadened to include achieving inflation targets, stimulating the real economy, and containing the European sovereign debt crisis. The European Central Bank and Bank of Japan focused their programs on direct lending to banks—reflecting the bank-centric structure of their financial systems — while the Federal Reserve and the Bank of England expanded their respective monetary bases by purchasing bonds.

There are two aspects of current central bank actions – credit easing and quantitative easing. Credit easing policies reduce interest rates. Rates for these four central banks is at zero-lower-bound (ZLB) or zero-interest-rate-policy (ZIRP). Quantitative easing policies unusually increase the size of central bank liabilities – currency and bank reserves. It injects money into the economy. Both types of policies weaken the currency of the central bank.

BoJ was the first one to introduce ZIRP, in February 1999. Federal Reserve reached there in 2009 after cutting rates from above 5% in 2007. BoE reached that range, but at slightly above Fed’s rate, few months after Fed and from a similarly high levels. ECB reached a level slightly above BoE’s rate few months after BoE and from a lower starting level. ECB once raised rates in 2011 only to cut it few months later.

Once central banks reached the ZLB range, their interest rate differential stopped playing a part in the currency movement. However, their QE policies have an impact on the currencies. Other factors that affect the forex rates is the relative strengths of these economies. The present situation is that the Fed has wound down its QE3, although, it is still maintaining a loose monetary policy. ECB is embarking on a QE expansion. BoJ is maintaining its QE policies and may enhance them. BoE is maintaining QE and though some were betting that it could be the first one raise rates, now the thinking is that it may need to boost QE.

The current stance of major central banks is dollar positive – Fed’s policies are favoring strong dollar; ECB’s are leaning towards weak euro; BoJ is weakening yen; and, BoE is at a crossroad. Also, the U.S.A. economy is doing better than other economies, which is dollar positive too.

The technical analysis tells us that the dollar index is reaching a resistance zone with a bias toward an up break or a consolidation. Euro is at or below a support level with a bias toward either a break down or consolidation. Pound is near a support with a bias toward consolidation. Yen is also near a strong resistance (bearish for it) with a bias toward consolidation. The trading strategies for these should be toward their major biases with tight stops.