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Could a 'Hawkish Cut' Lead to the Next Major $USD Rally?

Posted by Mark Meadows, TopstepFX on July 29, 2019

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In November 2017, the Bank of England hiked interest rates for the first time in 10 years. The market dubbed that a “dovish hike,” encapsulating the idea that though the BoE hiked interest rates, it provided forward guidance that made it very clear it would not be hiking in the near-term future. Then, Brexit uncertainties grew and the BoE has not hiked interest rates since.

Right now, the market is high on euphoria around the Federal Reserve lowering interest rates. But what happens when it’s a hawkish cut? The Dollar gets sent on its next leg higher, that’s what.

Our base case: the Fed rate cut will be the impetus for the Dollar to strengthen—maybe not immediately, but in the days and weeks after.


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Dollar Rallies Post Fed

EUR/USD has rallied into or following each of the Federal Reserve announcements this year, even as the rate cut became more and more likely. Yet afterward, EUR/USD fell—mostly to new swing lows. Let’s take a closer look:

FOMC Announcement Date

Post FOMC High / Time to High

Post FOMC Low / Time to Low

January 30

1.1500 / Two trading days

1.1235 / 14 trading days

March 20

1.1450 / Day of announcement

1.1185 / 11 trading days

May 1

1.1265 / Day of announcement

1.1105 / 20 trading days

June 19

1.1405 / Five trading days

1.1180 / 10 trading days

 

One of the oldest axioms in trading is that you can tell the strength of the trend if the market goes up on bad news or down on good news. The FOMC reversing its tightening stance would be considered bad news for the U.S. Dollar. Yet the Dollar keeps rallying. Why?

Three reasons:

  1. Where else do investors have to go? The entire German, Swiss, and Japanese interest rate curves are yielding negative rates. Heck, even German junk bonds are in negative territory. $13.5 trillion in global interest rates are yielding negative rates. If you are an institutional investor, where are you going to go?

    The dichotomy that we’ve seen is that they’ve gone into Treasuries… and into high-tech or large-cap U.S. stocks. That’s why the Nasdaq and S&P 500 are near all-time highs. Flows from overseas into U.S. assets will continue to prop the U.S. Dollar, even as it would traditionally become less appealing versus its peers.

  2. There is a global shortage of U.S. Dollars. What is quantitative tightening? It’s when the Federal Reserve pulls U.S. Dollars out of the global monetary system. At the same time, as the U.S. Dollar strengthens, which causes demand for Dollars to skyrocket from international economies that borrow in the world’s reserve currency. It’s a self-fulfilling cycle that then leads to more Dollar demand and Dollar strength.

    This doesn’t even account for the underlying bid for U.S. Dollars coming from China. That’s why China instituted strict capital controls that make it even harder for Chinese investors to remove their money from the country. China, and its slowing economy, are hooked on Dollars.

  3. The technicals. We are clearly in a strong Dollar trend. We don’t get too complex with our technical indicators. Lower highs and lower lows means that EUR/USD is in a downtrend. In addition, zooming out to the daily chart, it appears that a head and shoulders formation (a topping pattern) was developing, which also appears to be resolving to the downside.

So where’s the light at the end of the tunnel? Markets target unresolved areas. The big one for the EUR/USD is the gap from April 2017. That’s when EUR/USD gapped higher following Euro-positive results from the preliminary French presidential election. In that, the price moved from 1.07 to 1.09 on its way on a seven-month rally to highs at 1.2550.

That gap needs to be filled.

But not just that, the aforementioned head and shoulders pattern that started in July 2017, put in a head between January and May 2018, and is currently putting in a lower and lower right shoulder. Theory on this technical pattern would tell you that the downside target is equidistant from the top of the head to the neckline, which is about €0.10.

That would actually put a target of EUR/USD of 1.0550 if the strong Dollar trend resumes.

The Flaw in the Death Star

Every argument has a flaw, and every trader needs to know when they are wrong. At writing, EUR/USD is at a pivotal point below 1.12. To keep the downward trend going, it will need a sustained break below 1.1105, a level that is not far away in pips, but may be in terms of support.

That will really open up the downside towards that 1.09-level.

If the price does not fall below 1.11, then it opens up the potential that EUR/USD may switch trends—going from a series of lower highs and lower lows to a series of higher lows and higher highs. For that trend to take hold, EUR/USD will have to rise above the 1.1415 high from a month ago.

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Topics: US Dollar, EUR/USD, Currency Pages, trading strategy, TopstepFX

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