By Saikat Chatterjee and Ritvik Carvalho
LONDON (Reuters) – The dollar’s near-5 percent rally against a basket of currencies in the space of just three weeks has brought it up against some critical technical levels, which could give fresh legs to the greenback if successfully broken.
The initial catalyst was the realization that some of the world’s biggest central banks, notably the European Central Bank, would not in the near-term follow the example of the U.S. Federal Reserve in raising interest rates from crisis-era lows.
But there are other factors too. From the widening interest rate differential in favor of the United States to investors’ need to unwind some of the short dollar positions they had built up over the past year and low market volatility, all these are conspiring to make the dollar more attractive.
“It is certainly shaping up to be another incredibly bullish trading week for the greenback, which has punched above 93.35, its highest level this year,” said Lukman Otunuga, a research analyst at FXTM, a currency broker.
“The dollar index remains heavily bullish on the daily charts as there have been consistently higher highs and higher lows.”
Graphic: Dollar index breaks above 200-DMA for first time in a year – https://reut.rs/2In9e7R
On three major market metrics — valuations, positioning and technical indicators — the dollar looks set for more gains, market players reckon.
Against some of its major rivals, the dollar is perched at some key technical levels.
David Madden, markets analyst at CMC Markets reckons the dollar has recently completed what is known as a “double-bottom” reversal.
Graphic: Dollar marks double-bottom reversal – https://reut.rs/2IoqMQP
According to technical analysis website, StockCharts.com, this is a bullish reversal pattern, made up of two consecutive troughs that are roughly equal, with a moderate peak-in between.
“There’s a good argument to be made that the downward trend that was in for a while, has been negated because the lows we saw in January and February were multi-year lows,” Madden said.
“So we could push on higher from here.”
For instance, the dollar broke through a 200-day moving average against the British pound last week for the first time in a year. A rise to around $1.3257 would mark the 50 percent range of the pre-Brexit referendum high of $1.5022 and an October 2016 low of $1.1491.
The euro has also lost momentum after scaling a 3-1/2 year high of $1.2556 in mid-February and is now down more than 1 percent on the year, a remarkable turnaround fom last year when it gained more than 10 percent against the dollar.
Market analysts now expect the euro to weaken to as much as $1.1747.
On a positioning basis too, the stars appear aligned for further dollar gains, given the overhang of record short bets against the greenback.
Graphic: Bear hug – https://reut.rs/2IpraPb
While short-dollar bets have seen a sizeable drop in the last two weeks, according to speculative positioning data from Commodity Futures Trading Commission, a sizeable $18 billion in positions still remain, far more than recent averages.
Banks’ survey data also indicate the same. Bank of America Merrill Lynch (NYSE:BAC) monthly survey of funds showed in April that short dollar bets remained well above historical averages, indicating the dollar has more room to strengthen as these bets are unwound.
Finally, despite the dollar’s recent surge, it still stands below its median value on a 20-year horizon, according to a JP Morgan trade-weighted dollar index.
Graphic: Fairly valued on a historical basis – https://reut.rs/2ItjqvA
The dollar also offers some of the highest returns thanks to rising yields on the short end of the interest rate curve.
Two-year U.S. Treasury yields are above 2.5 percent, its highest in nearly a decade. So investing in dollars by borrowing in euros offers a chunky yield of 3 percent over a one-year horizon.
That yield has become more attractive as currency market volatility has plumbed to new lows. Three-month implied volatility on the euro-dollar is now at its lowest levels in four years.
Goldman Sachs (NYSE:GS) strategists say the “carry-to-vol ratios” or returns adjusted for expected market swings for most currencies are at or close to multi-decade highs, indicating more upside for the dollar in the short term.
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