The US Dollar experienced a significant technical breakdown in the past week following a noteworthy policy reversal admission from the Federal Reserve (Fed). The Fed's comments and subsequent press conference pushed the Dollar index below its 200-day moving average, resulting in a notable decline. However, this shift could potentially mark a bottoming process for the Dollar, hinting at a potential reversal in fortunes.
Dollar's Technical Breakdown
The Dollar's decline gained momentum as the Bank of England and the European Central Bank (ECB) refrained from signaling imminent rate cuts, in contrast to the Fed's policy shift. This divergence caused the dollar index to plummet by 2% in just two days, marking its most substantial sell-off since July. While this sharp decline may seem ominous, it's essential to consider historical context.
Back in July, a similar steep drop marked the conclusion of the Dollar's descent, paving the way for an extended upward trajectory. The current situation presents an opportunity for a potential bottoming process in the Dollar, which could lead to a resurgence.
Fundamental Factors Behind the Dollar's Decline
The primary driver behind the Dollar's sell-off was a significant reassessment of interest rate expectations. Following the Fed's acknowledgment of three rate cuts in 2024, the market swiftly demanded a more aggressive stance, pricing in a total of six rate cuts. According to FedWatch, futures now indicate a 15% probability of a rate cut on January 31 and an 80% chance on March 20, 2024. This contrasts with the situation just two months ago when the Dollar index was peaking, with a 40% probability of higher rates in March and a 50% chance in January.
However, the rationale behind six rate cuts appears challenging to justify, especially when considering the robust performance of the US economy. Retail sales are on the rise, wages are outpacing inflation, and job creation remains robust. Therefore, the excessive rate cut expectations might be influenced by technical factors. Many investors had sold US government bonds before October but have found them attractive again in recent weeks. This shift has contributed to the rally in US equity and bond markets, driving the sense of FOMO (Fear of Missing Out) and amplifying market dynamics. It's important to note that this surge occurred despite reasonable macroeconomic valuations.
Normalization of Expectations and Dollar's Prospects
In the coming days and weeks, there may be a normalization of interest rate expectations. This shift could work in favor of the Dollar and potentially temper excessive optimism in the equity market. Additionally, the divergence in economic performance between the US and Europe plays a role. Europe, despite wage growth, is grappling with numerous challenges, while the US is displaying strength across various economic indicators.
The current market scenario is reminiscent of the post-financial crisis recovery, where the Eurozone struggled with weak growth compared to the US. This dynamic highlights the potential for a resurgence in the Dollar's strength, underlining the importance of considering broader economic contexts when assessing currency trends.
As market participants adjust their expectations and gain a clearer perspective on the economic landscape, the Dollar may find its footing and embark on a path to recovery.
