Last week the minutes of FOMC’s April meetings were released. For some time, the market was anticipating that the Fed will keep the option to hike rates in June open. Hence the dollar had been gradually rising along with the volatility in the equity market for the last few days. The initial reaction of the market after the release was quite negative and the minutes were seen as hawkish by the market participants and analysts, thus increasing the probability that Fed will raise in June meeting.

Some, on the other hand, are not so convinced about the intended trajectory of Fed’s rate decisions. One of them, Komal Sri Kumar of Sri-Kumar Global Strategies, in fact wrote in a blog post, “I expect the downturn in markets from the release of the Fed to be reversed during the coming months as the global and domestic impact of the announcement leads to corrections in equity markets, puts pressure again on the Chinese currency, and pushes the ECB to follow expansionary measures to try to further strengthen the dollar.” He believes that the data-dependent Fed will not find data supporting its decision to raise rates as telegraphed. On the other hand there are many, including some Fed members, who are insisting on a gradual path for the Fed-rate to normalcy. Under this background let’s review the US dollar index.

Long Term Dollar Index Activity

After the Plaza Accord reset the pecking-order of the major currencies, the US dollar – measured against a basket of currencies – declined consistently from the 1985 high of 128.180 to the 1992 lows of 78.430. For a decade – from November 1989 to November 1999 – the US dollar index remained in a trading range that had an upper bound within a range of 98-103 and a lower bound near 80-78.

During this period the index made three attempts to break below 78 – first in February 1991 then in September 1992 and finally in April 1995. In between these attempts to break below, the index twice tried to rise above the resistance level near 98 handle. After the third failed attempt to break below 78, the index consolidated for few months before making a big bullish engulfing candle in August 1995. The rise after that briefly stalled at the upper range in 1997 before breaking out in early 2000 finally peaking in July 2001 at the high of 121.290.

The 9-period RSI during the rally from 1995 first reached overbought territory in 1997 (see points X1 on the chart). RSI’s next in the overbought region occurred in 2000 and 2001. However, its level in 2000 and 2001 were lower than that in 1997 whereas the index was at a higher level (see points X2 and X3 on the chart).

This divergence was too much and the dollar index consistently declined in ’00s like it did in ’80s, finally reaching a low of 71.050 in April 2008 during the financial crisis.

Between 2006 and 2014, the US dollar index carved out a price-action similar to that of in ’90s. Three times it tried to break the lows near 71-74 and twice it tried to break the resistance near 90-89. Finally it cleared the this trading range in early 2015.

However, that break above the trading range of 2006-2014, stalled at the resistance level formed in 1990s near 100 level. After 2008, the RSI travelled in overbought region in 2014 peaking in March 2015 (see point X4 in the chart) when the index reached a high of 1000.785. The second attempt to go above this high failed in December 2015 when RSI made a lower high too (see point X5). Still, this was not a divergence.

The May 2016 low of 91.88 found a support level created by the 2005 high. May is only three fourth way done but if the dollar ends the month at current level then it would form a bullish engulfing. As far as the measured target from chart patterns are concerned, the index hasn’t reached them yet.

Between 2008-2004, the index made a horizontal channel. The measured target of this chart pattern is near 106 level. It has also retraced up-to 61.8% (a Fibonacci level) of the decline from 2001 highs to 2008 lows. In ’90s it retraced more than 78.5% (another Fibonacci level) of the 1985 to 1991 low.

On weekly time-frame dollar’s price action provides more insights.

After the second attempt to break above 100.78 level in November 2015, the index formed a down-sloping flag. This is usually a bullish formation. The week of 05/02/16 candle was bullish in nature, it was also a Wyckoff Spring and a piercing candle reversal pattern. If the push from these patterns take the price above 95.921 then it would have broken the down-sloping flag to the upside and the next resistance would be at the March 2015 high of 100.780. If the index breaks that resistance then the breakout move would from a horizontal channel with a measured target near 108, which is near 78.6% retracement of the 2001-to-2008 decline.

The price-action during the last few months has brought the dollar in the mid-range of its total price swing since the Plaza Accord in 1985. Also, chart tell us that based upon history and prior patterns, dollar index has more room to go higher. But, for that to happen it would need help. Let’s see if that is going to come.

The Active Central Banks

The political will to address the aftermath of the 2008 financial crisis had been lacking globally. This meant that most major economic players around the world have not used the fiscal policies to engineer recovery. This has left monetary policy to be the only available weapon and the central banks the only active players. Almost all the tools – interest rates, QE etc. – at their disposal to create and sustain recovery relate to debasing their respective currencies.

If one currency loses value due to the monetary action of its central bank then other currencies gain in relation to it. Federal reserve was first major central bank to cut rates and adopt QE. This resulted in weaker dollar early on. Part of this was offset due to the panic that resulted from the crisis. Historically, dollar, along with Japanese Yen and Swiss franc, has served as a safe asset during global panics. So it strengthened from April 2008 to March 2009 and from December 2009 to June 2010. During this time Fed was aggressively loosening monetary policy, which started to result in recovery. But it also kept dollar weakened till April 2011.

By this time Japan had embarked upon its Abenomics and ECB had made a U-turn from its foolish rate hike in 2011. By late 2011, both  of Japan and ECB were either loosening monetary policy or the market was getting convinced that they would have to. The recovery was taking foothold in US and her economy was looking better that Europe’s and Japan’s economy. the result was that since September 2011, dollar index is facing more of a tailwind than head-wind.

Euro weakened with respect to dollar from May 2011 to July 2012 and then in more earnest from April 2014 to March 2015. Catalyst for these moves were mostly the increasingly loosening of the monetary policy by ECB when the Fed was either standing pat or jawboning back-to-normalcy-policies.

The impact of Abenomics and BOJ’s policies were more pronounced and the yen fell like a rock with respect to dollar from September 2012 to June 2015.

Dollar rise accelerated by the end of 2014 and finally the Fed raised rates in 2015. The result was that the index reached highest level of a decade in March 2015.

Jittery Markets

Since December ’15 Fed rate-hike, the global equity markets are spooked due to more tightening by Fed and by slowing Chinese economy in particular and emerging economies in general. However, the post financial crisis central-bank-driven economic environment is such that it has created a feedback mechanism that says that any market turmoil – even the ones fueled by Fed hawkish – will lead to Fed becoming dovish again.

So any further strengthening of dollar depends upon an orderly market, which – since the financial crisis – has depended upon loose Fed policy. Now is the good time to test the hypothesis that the market are not stable and rising because of the Fed policy but because of improving economy.

Do Commodities Influence Inflation?

Fed has dual mandate to maintain full employment and stable prices. The unemployment rate has been dropping for a long time and at 5.0%, the economy seems to be at the full employment. However, the inflation is not near Fed’s target rate of 2% and has not been for a very long time.

Dollar has an inverse relation ship with commodities as they are dollar denominated. Which means that if the dollar rises then the commodities will fall. The Bloomberg Commodities index has been falling since April 2011. It spiked up just before the financial crisis but then fell more that 60% in its aftermath by February 2009. By April 2011, the index recovered more than half the decline. However, since then it has been declining consistently. By the end of 2015, it had reached all time lows.

Commodities have a direct relationship with inflation. When they fall significantly they dampen inflation. Commodity index’s current level does not bode well for inflation.

At the moment the Global Price index of All Commodities is diverging from the CPI. Commodity prices are declining but the CPI is showing an uptick. They usually trend together with a small lag.

These two briefly diverged in 2001 and in 1999 when the CPI was rising but the commodities were falling. Both times CPI followed the lead of commodities and declined. If that historical relationship holds this time too then CPI would turn back to follow commodity prices. If that happens then the Fed will have less of a reason to justify it continuing with the planned rate hike and what Komal Sri Kumar wrote in his blog will hold true.