After suffering selling pressure since the turn of the year, the US dollar (USD) found some strength to engage in a technical rally on Friday. How markets now react to this potential turnaround will be important in the coming days.
- A “long squeeze” has been playing out for USD as the Fed's tightening of interest rates has become increasingly priced in.
- Major pairs have turned increasing USD corrective. There may be more to come.
An unwinding of USD strength
According to CFTC (Commodity Futures Trading Commission) data, net futures positioning for the USD has shifted significantly in the past six months. The market has gone from being decisively net short of the USD to being decisively net long. This has been a key driver of the USD strength in that time.
This has been a period in which market participants have moved to price in a growing number of rate hikes by the Fed in 2022. Starting with an expectation of around one 25 basis points hike (+0.25%), the market is now pricing closer to four hikes this year.
However, all this now seems to be priced in. Traders are no longer getting the same bang for their buck from talk of tighter interest rates. Futures positioning are set up for a “long squeeze” (where long futures contracts are closed, leading to selling pressure on the USD).
Although the futures contracts are not yet reflecting it, this may already now been happening in the past couple of weeks.
Friday’s USD rebound leaves markets interestingly poised this week
So after the selling pressure of the past couple of weeks, which has driven decisive moves on major pairs such as EUR/USD, GBP/USD, and USD/CAD, the emergence of a technical rally on USD on Friday poses a few questions for traders. Primarily, the issue is whether the USD can now begin to recover again.
It means that reaction to the key breakout levels on EUR/USD and GBP/USD and breakdown levels on USD/CAD will be important this week.
The Dollar Index broke down decisively last week with a move below 95.51 which also resulted in a breach of the primary uptrend.
The old uptrend is now a basis of resistance between 95.15/95.30 this week, whilst the old breakdown level at 95.51 is also an area of an overhead supply of sellers.
The key break levels to watch on major pairs
The outlook on EUR/USD has shifted significantly in the past week. A market going nowhere decisively broke higher through a two-month resistance band at 1.1360/1.1385. This completed a 200 pip base pattern and imply a potential recovery target of 1.1585. The move also broke the primary downtrend (the chart is almost the mirror image of the Dollar Index).
However, Friday’s one-day candle has put a fly in the recovery ointment. A “bearish engulfing” candle is a negative for the near-term outlook. It means that reaction to not only the old downtrend (which is theoretically now supportive) but also the underlying demand of the old breakout at 1.1360/1.1385 is now key. If the bulls use this unwind as an opportunity, to build support and place a new higher low, then the sustainability for the recovery will be strengthened this week. A pullback to find support around the breakout is a strong signal.
The improvement in momentum seen in the past week is certainly a positive. The Relative Strength Index (RSI) moved into the 60s to confirm the breakout and strengthen medium-term momentum. We favor this to be an opportunity for the bulls and position for a move towards at least a test of 1.1480/1.525.
GBP/USD has also broken a primary downtrend and moved through key resistance, at 1.3570/1.3600. Once more, a near-term drag back of this recovery should be seen as an opportunity to buy. The strength of the momentum gives us the indication that further recovery gains will be seen (RSI hitting into the 70s is a decisive bullish signal). We favor a continuation of the run higher, with the resistance at 1.3835 our initial target.
Subsequently, the support of the breakout at 1.3570/1.3600 becomes key, also an area around where the old downtrend is a basis of support. We would see an unwind into this area as another chance to buy.
The third pair that we feel is of key importance for USD this week will be USD/CAD. The pair has been in a broad trading range between 1.2290/1.2965 for the past six months. A decisive bull run on the oil price as USD has been weakening has had the double impact of dragging USD/CAD lower recently.
A breach of support around 1.2600 completed a “head and shoulders top” last week. The pattern implies 1.2240 over the next couple of months. This means that a retreat to the bottom of the range at 1.2290 is certainly possible.
Friday’s pullback rally for the USD has seemingly done little to change this and looks to be another chance to sell. There is now a key 50 pip band of resistance 1.2570/1.2620 to use as a near-term sell zone.