US Dollar Forecast

Q3, 2018
John Kicklighter, Chief Strategist
jkicklighter@dailyfx.com
http://www.Twitter.com/JohnKicklighter
James Stanley, Strategist
jstanley@dailyfx.com
http://www.Twitter.com/JStanleyFX

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US Risks Isolating the Dollar, Boosting its Risk

John Kicklighter, Chief Strategist and James Stanley, Strategist

A Shift in the Dollar’s Standings and in the Fundamental Landscape

The US dollar spent the first half of 2018 trying to pull out of a tumble that lasted the entire preceding
year. It finally began to make progress in its recovery effort through this past quarter with an
approximate 6 percent charge on a trade-weighted basis (as in the EUR/USD-heavy DXY Index) and
around 5 percent on an equally-weighted measure across its most liquid counterparts. This recovery is
still in its fledgling phase in technical terms heading into the third quarter, but it may struggle to
mature much further as fundamental conditions start to turn out of its favor.

Looking for motivation to the Greenback’s bearings, it is first worth establishing what initiated the
course reversal in the first place. Evaluating the move with a more objective eye rather than being
swept up in a speculative opportunity, many of the familiar drivers did not seem to solidify behind the
currency’s effort. Relative growth certainly has not shifted in the United States’ favor. The extreme
safe haven role the currency reverts to in tumultuous times has yet to find a crisis upon which it can
profiteer. And, even on the opposite end of that speculative spectrum, the benefits derived from the
Fed’s unrivalled monetary policy bearing come with a hefty dose of skepticism – consider it maintained
a hawkish advantage through 2017 as the currency tumbled.

Looking ahead to the second half of the year, there is certainly a course the dollar could weave to earn
further gains. That said, the qualified drivers are unlikely to arise – or more importantly coincide – in
order to facilitate genuine support for the currency. Trade wars, the wavering in global sentiment and
convergence of monetary policy paths create a difficult environment for bulls.

Trade Wars and The Very Real Risk of the Dollar Losing Top Reserve Status

Through the end of this past quarter, the world was fully emerged in trade wars. While the opening
moves of this economic conflict started with a global setting, the pressure was clearly concentrated
between the United States and China. The blanket Steel and Aluminum tariff the US announced against
all of its trade partners found the expected retaliatory response from its largest economic counterpart.
From there, the escalation between the two moved onto reprisal for perceived intellectual property
theft. A $50 billion tax on an array of Chinese products elicited a quick tit-for-tat response from China.
Both countries fundamentally believe they are merely responding to instigation, which threatens to
escalate this particular front in the economic war to destabilizing levels. US President Donald Trump
responded to China’s retaliation by threatening a massive $200 billion escalation.

The risk here is not that these two countries will keep going. They will not as both have inevitable pain
threshold whereby the domestic implications will simply be too costly. However, if they push their spat
too far, it could irreparably undermine a decade of speculative charge for capital markets, which has
arguably stretched far beyond the reasonable bounds of economic and financial performance over the
period. We are at even greater risk of tipping the scales should the US pursue the same degree of
aggression against ‘developed world’ counterparts. China is a behemoth and its financial stability is
vital to the health of the global economy. That said, there is something of a buffer in that the country
has remarkable control over its own economy and markets, not to mention its controlled capital
borders can dampen spillover. This cushion does not exist between the US and the open European
Union economy. After the US decided to push forward with the metals tariffs against the EU (the
world’s largest aggregate economy), the regional leaders unanimously agreed to respond with its own
list of taxes against US products. Following the same script for massive escalation, President Trump
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made a clear threat in a Tweet that he was considering a 20 percent tax on all imported European cars
– a significant economic hit should it be enacted.

It is easy to be caught up in the direct and immediate implications of this escalating threat. The steady
increase of these combative policies can permanently restrict global growth and the global flow of
capital. Yet, one of the important consequences of this situation is the likelihood that the afflicted
trade partners with the United States will coordinate a punitive response to the country for its
aggression. That carries obvious fundamental implications, but the more permanent fallout would be
the threat to its position as the world’s speculative and economic center. The US Dollar, Treasuries and
various speculative benchmarks hold a unique status in the global markets – supported by both the
scale of the economy and an implicit expectation from previous generations. Whether intended or not,
an organized response against the US would see capital diverted away from its markets and currency.
And, once that alternative course is made, it would not simply rebound to its previous levels once the
storm passed as the world was already looking for a reason and means to diversify. This is what we
would consider a possible permanent downgrade for the Dollar rather than a temporary or cyclical
one.

Graph created by John Kicklighter and Peter Hanks

Changing the Safe Haven Qualities Behind the US Dollar

By most measures, the world’s markets stretched well beyond their traditional fundamental value over
these past years. The violent heave in volatility and sharp retreat in speculative benchmarks starting
around February this year called attention to the imbalance while still falling far short of the point a
reasonable person would consider the markets once again ‘balanced’. Looking ahead, it is inevitable
that there is a reckoning – it is only a matter of time. How quickly the return to value occurs depends
on what motivates the search for equilibrium. Once again, trade wars are a perfect medium for panic
and gateway for broader concerns, not to mention they are immediately at hand.

The real question in this estimation of fundamental drive is where the dollar will stand when the wave
crashes. Should sentiment skip from rosy complacency to full global financial crisis, the US currency
may very well leverage its renowned liquidity as fund managers, banks, large investors and others find
little time to split hairs on future intentions to diversify. That said, any degree of risk aversion shy of
catastrophic anxiety will allow market participants the necessary room to question fit. Redirecting
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capital to the US will carry the consequences of implicit capital curbs brought on by the country’s being
treated as a pariah for its trade policies and fiscal profligacy.

Graph created by John Kicklighter

An Advantageous Monetary Policy Could Turn Into a Liability

There is another troubling feature of the Greenback’s landscape moving forward should general
sentiment begin to fade. Since the Federal Reserve hit the full swing of its ‘taper’ effort to ween off a
massive stimulus program (QE3) in mid-2014, the Dollar has been labeled as a leading ‘hawkish’ central
bank amongst the majors. That designation was not particularly flattering given the field, but it came
with remarkable speculative credibility. The lift this unique stance afforded the currency was sizable,
but it didn’t earn the currency a permanent pass to advance unchecked until the Fed hit its peak or the
rest of the world fully caught up. The Dollar noticeably tumbled through 2017 despite its central bank
tacking on another three 25 basis point rate hikes through the year. All of its largest competitors were
either struggling to make a shift from ‘neutral’ or were outright dovish.

Now, the benchmark currency is left with a fundamental ‘advantage’ that has lost its ability to sustain a
steady advance. Even if we attribute the second quarter gains to a shift in value towards yield, the
best-case scenario is dubious strength. A more practical course moving forward amid faltering risk
appetite would see the Dollar reconnect to rate forecasting as those very projections collapse.

Chart prepared by John Kicklighter

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Technicals: Dollar’s Conviction Hinges on 91.36

The US Dollar finally found some element of support after what ended up being a brutal 13-month
downtrend. After the Greenback topped-out in the first few trading days of 2017, bears retained
control as the currency shed as much as 15% in what became a tumultuous year-plus tumble for the
US Dollar. Support eventually showed up at 88.26, which is the 50% retracement of the 2011-2017 bull
wave from the US Dollar/DXY. This stability started to show in February, but as we wrote in last
quarter’s report, bulls were simply unable to seize the scenario and prices continued to move within an
expanding range as we closed Q1 and through the first month of Q2.

US Dollar via ‘DXY’ Monthly Chart: Support Catches at 50% Marker of 2011-2017 Major Move

Chart prepared by James Stanley

Dollar’s Tide Begins to Shift in April, Continues into Quarter-End

The US Dollar remained in its expanding range through the first few weeks of Q2, but strength
eventually started to show more muscle in the last week of April. The primary driver here was
interesting, as it was a bearish move in EUR/USD around the ECB meeting on April 26th that seemed to
really stoke the US Dollar’s bullish drive. That theme of EUR/USD weakness and US Dollar strength
largely remained throughout the month of May and well into June, even as the European Central Bank
announced details on their strategy to taper QE later in the year.

This pair-specific influence helped the US Dollar to further recover from last year’s slump, and prices
have already moved back-above the 38.2% retracement of last year’s bearish trend. This sets the stage
for a re-test of a zone of confluence that runs from 96.04-96.47. This area contains both the 50%
marker of the prior downtrend as well as a 23.6% Fibonacci retracement of the 2011-2017 move.

US Dollar Weekly Chart

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Chart prepared by James Stanley

Q3 Forecast: Looking for a Return to 98.00

As we move into the third quarter and second half of the year, the stage appears to be set for a
continuation of US Dollar strength. Given the pace of the recent move, combined with the divergence
that’s shown in rate expectations around the world, the backdrop appears to be supportive for a
continuation of this theme.

Above that zone of resistance that runs from 96.04-96.47 is another area of confluence to watch
around the 98.00 level on DXY. This level hosts both the 61.8% retracement of the prior downtrend as
well as the 23.6% marker of the 2014-2017 bull trend; and a topside break to fresh yearly highs above
96.50 opens the door for a re-test of that key area on the chart.

US Dollar Daily Chart: Targeting Tests Towards 96, 96.50, 98.00

Chart prepared by James Stanley

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