The US dollar is about to face its next big test

Photo by Justin Sullivan/Getty Images

The US dollar index, or DXY as it is often referred to, just can’t seem to break out of the trading range it has been stuck in over the past two years.

As shown in this chart from ANZ, it’s been stuck in a relatively thin range between 94 to 100, finding plenty of support on the dips which all but vanishes when it approaches 100.

The DXY is a measure of the US dollar’s value against a basket of six major currencies with the euro and Japanese yen accounting for around 70% of the weighting.

Like the Australian dollar above 77 cents in recent months, it just can’t find the catalyst to breaker higher.

Now, at 98.63 — near the highest level seen since early this year — the DXY looks like it’s about to flirt with the 100 level yet again.

As Khoon Goh, head of Asia research at ANZ, indicates, the question everyone is now asking is what, if anything, will be enough to see the DXY break higher?

“The DXY index is nearing the important 100 level, which has proven to be a key technical resistance level,” he says.

“Since 2015, the DXY has surpassed that level twice, only for it to retrace lower.

“So while that psychological level will remain a magnet for currency markets, it will require a major catalyst to propel the DXY beyond it.”

After pondering that question, Goh believes he has the answer.

It’s not a rate hike from the Fed in December, nor the prospect of a Hillary Clinton victory at the November 8 US presidential election, he says, pointing out that “markets have already largely priced those events in”.

Instead, it’s a combination of factors that he believes could see the DXY break higher: an acceleration in inflation, volatility in capital flows into emerging markets and a shift in political risk from the US to Europe.

“What will give the USD another leg higher are further signs that inflation in developed economies are accelerating,” say Goh, adding “higher inflation means inflation expectations should rise and lead to steeper yield curves.”

He suggests that a “combination of Fed policy normalisation, steeper G7 yield curves, and reduced expectation of more stimulus from the BoJ and ECB will likely result in more volatility in capital flows into emerging markets, including Asia,” something that would likely support the DXY should flows into emerging market assets reverse.

The final factor to consider are political risks from Europe, he says, picking out the Italy referendum on constitutional reform to be held on December 4, along with ongoing Brexit-related concerns, as areas for particular attention.

“We are also mindful that once the US election is out of the way the focus will shift towards Europe, as the region enters an intense election cycle next year with unemployment high, income growth negligible, and opposition to deeper EU integration rife,” he says.

“Should the Italian referendum fail — which opinion polls suggest it will — there may be an election called in Italy early next year.

“Elections are also planned in the Netherlands, France, and Germany in 2017. These suggest some political risk premium will be priced into the EUR and we look for a move down towards a 1.00- 1.05 range over the coming months.”

As a result of these factors, Goh believes it favours the US dollar “for the time being”.

While he has stopped short of calling for a sustained break higher in the DXY above 100, a level technical traders will be watching closely should a re-test arrive in the period ahead, Goh says that he expects the “USD to fare well”.

The US election will be held on November 8. That will be followed by the US Federal Reserve’s December FOMC monetary policy decision on December 14.

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