Why the US dollar rally may run out of steam this week

<p>For the past several weeks, we’ve been using the analogy of a pendulum swinging from side to side to explain the gyrations in market sentiment […]</p>

For the past several weeks, we’ve been using the analogy of a pendulum swinging from side to side to explain the gyrations in market sentiment toward the dollar and the Federal Reserve. Two weeks ago, we noted that “the dovish-Fed / bullish-risk-asset pendulum may be reaching its apex” and that “conditions are increasingly ripe for traders to start pricing in an increase interest rates, especially if economic data starts to stabilize or improve in the coming weeks.”

As it turns out, this thesis has played out nicely, with the dollar surging over the last two weeks on the back of a less-dovish-than-expected FOMC meeting, though US economic data was hardly more optimistic over this period. In terms of interest rate expectations, the market has gone from pricing only a 30% chance of a Fed rate hike before the Fed statement to exactly 50% now, according to the CME’s FedWatch tool.

While we hesitate to stretch the pendulum analogy too far, it’s worth noting that a pendulum reaches its maximum speed at the trough between the two extremes, and the US dollar index may be at that pace now. According to the rate-of-change indicator, a classic measure of a market’s velocity, the dollar index, has rallied over 300 pips over the last 10 days; over the last six months, the 10-day ROC indicator has tended to roll over once it reaches the 300-400 pip range, though the index itself generally continues to rally into the next week.

In other words, the pace of traders shifting to become dollar bulls (i.e. Fed hawks) may be reaching a near-term peak, though some stragglers could still push the greenback higher in the coming week.

Looking at the chart of the dollar index itself, there is a strong resistance zone upcoming in the 98.00-98.50 region (mirroring EUR/USD support in the 1.0800 area). Unless we see some solidly bullish US economic data that tips the scales in favor of a December rate hike (Friday’s Non-Farm Payroll report will be key), this resistance zone could mark a potential top in the dollar index as traders remain hesitant to place large bets heading into an unpredictable FOMC meeting. If we do happen to see the 98.50 resistance level eclipsed, the buck could rally back toward the 100.00 level next.

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