Why the US dollar rally could be about to reverse, in one chart

Total Recall. IMDb. Carolco Pictures.
  • The US dollar index (DXY) hit a near one-year high on Tuesday.
  • A more hawkish Fed, and more dovish ECB, have contributed to the US dollar’s recent strength.
  • US economic data surprises compared to those elsewhere in the world have reached extreme levels, hinting that downside risks for the DXY could be building.

The US dollar is on the charge, rising to the highest level in close to a year on Tuesday.

As seen in the daily chart below, the US dollar index, or DXY for short, has been the standout performer across currency markets over the past four months.

Investing.comDXY Daily Chart

From trough to peak, the DXY has added 8% since February 16, mainly reflecting renewed strength against the euro, the largest component in index.

While there have been many factors behind the rally such as reversal of stretched short positioning, an increase risk aversion and softer economic data abroad, divergent monetary policy settings between the Federal Reserve and other major central banks has undoubtedly contributed to the move.

The Fed looks like it will tighten policy settings even faster in the months ahead. In contrast, many other central banks are signalling that they won’t be altering policy settings for the foreseeable future.

This divergence largely reflects that economic data in the United States is also far stronger than in many other nations and regions at present, including in the eurozone.

“A strong patch of US data in Q2 and a relatively more hawkish Fed have placed renewed focus on ‘US divergence’, providing ample fuel for the USD,” says Richard Franulovich, Head of FX Strategy at Westpac Bank.

“Against that Eurozone data has been weak into Q2, raising the possibility of a more protracted downswing and the ECB pushed back the possibility of a interest rate increase deep into 2019.”

As seen in this excellent chart from Westpac, the divergence in US economic data surprises compared to those elsewhere in the world has widened sharply over the past eight weeks, sitting well above average levels.

Understandably, the DXY — shown in black — has risen sharply in response.

Westpac Bank

However, given the divergence in US and global economic data surprises now sits near extreme levels, does that mean the US dollar is likely to fall in the period ahead as economic expectations adjust?

It does, after all, have a reasonable relationship to the ebbs and flows in economic data surprises.

Given the tendency for mean reversion from extreme levels, and sometimes even large overshoots, the indicator suggests a reversal in the DXY could be coming.

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