Sentiment Speaks: What's Next For The U.S. Dollar Now That The Shorts Have Capitulated

Summary

• The U.S. Dollar was heavily shorted in late 2020.
• Large deficit levels were to be the driving factor in the drop of The U.S. Dollar.
• The narrative was switched when the price did not cooperate with the story line.
• What Sentiment Analysis has to say.

The U.S. Dollar Index (DXY) saw a move higher of close to 5% from January 1st into the high struck on April 1st. That rally was preceded by a drop-off of the March of 2020 high which saw the DXY fall over 10%.

While few were calling for lower levels near the highs back in March of 2020 many were still calling for lower levels into the January lows. In fact, the recent rally off of the January lows rally came in the face of massive bets against the U.S. Dollar as the short dollar trade was, as Bloomberg put it, a "near-consensus call".

Bloomberg further summed up the rationale for the trade by stating,

…the U.S. deficit would encourage investors to favor assets outside of America - sinking the dollar and extending last year's 5% plunge.

This would have been a great story had the price of the U.S. Dollar cooperated with that narrative. Unfortunately, that story fell apart this year as the U.S. Dollar simply failed to comply. A new narrative has already been prepared to explain the "cause" of this recent rally off of the January lows.

Bloomberg now tells us,

…a relatively successful vaccine rollout in the U.S. and signs that further government spending will do more to boost the domestic economy than weigh it down with debt have traders changing course. That's buoyed rates, burnished the appeal of American investments, and prompted a rush to buy the currency this year.

The issue with this argument is that bond rates were already on the rise long before vaccines had even begun to roll out. The 10-Year T-Note had topped back in August of 2020 with bond rates seeing a move up more than 50 basis points into the January 1st levels. This trend rise in bond rates continued into April at the same time that the U.S. Dollar began its rally.

Furthermore, the biggest part of the drop in the U.S. Dollar occurred from May of 2020 to September of 2020. During this time period bond yields were relatively flat. So to say now that the current rally in the U.S. Dollar has anything to do with bond prices is simply not supported by the data. This data point can be seen in the chart below which overlays the Ten Year U.S. Treasury Note with the U.S. Dollar.

Chart By: Mike Golembesky

If the current rally fails to hold and the U.S. Dollar turns down once again, the pundits will surely have another story to tell and a new narrative ready to go. This story will be widely read and almost universally accepted by most, as this is what feels natural to us. Our brains are wired to assign a cause and effect and we feel uncomfortable when things don't make sense. So, assigning a seeming plausible cause to the movement of the U.S. Dollar gives us comfort. Unfortunately, the cause that was assigned, in this case, does not make sense when examined in just a little bit of detail. This assignment of exogenous forces to market movements will continue to be pushed out and read regardless of whether they make sense or are supported by the data as long as it continues to give us comfort.

For investors who are concerned with making a profit rather than feeling comfortable - a better approach than to assign exogenous forces to the price of the U.S. Dollar is to simply try to understand what the underlying driver of the price of the U.S. Dollar is and analyze that. That underlying driver, like that of any openly traded finical instrument, is simply investor sentiment. Investor sentiment is something that we do have the tools to analyze in a far more consistent and structured manner.

In fact, our sentiment analysis on the U.S. Dollar has been quite accurate and consistent since the top that was struck in March of 2020. On March 29th, we had warned our subscribers that the U.S. Dollar had likely topped with the spike into the March highs. We then followed that analysis up the following week on April 3rd noting to our subscribers that there was a setup in place for the U.S. Dollar to see lower levels.

Chart By: Mike Golembesky

In that April 3rd update, we published the chart above, which laid out the overall downward path for the U.S. Dollar. This chart showed targets for the DXY in the high 80s. Again, this was when the DXY was trading near multi-year highs at just over the 100 level in the midst of the global shutdown. Very few were calling for a lower U.S. Dollar at that time, as we approached levels not seen since 2017.

The DXY ended up bottoming at the 89.21 level in early January, at which time we were looking for the DXY to be forming a larger degree bottom. We saw early signs of this toward the end of December when we noted to our subscribers that the U.S. Dollar was entering its long-term target zone.

When the DXY struck the high last week it had stopped just shy of a key resistance level that I had laid out on our charts for several months. This may indeed be the spot where the U.S. Dollar may begin to see a pullback. If the high that we saw on April 1st ends up holding I can even make the case for the U.S. Dollar to see yet another lower low prior to finding a more sustained bottom. A new low is my alternate path for the time being, but, with the hold of resistance, it certainly is still on the table.

The structure of the next move down will be helpful in giving us further guidance as to whether lower lows are likely or whether this is simply a pullback as part of a larger corrective pattern to the upside. In either case, whether we see just a pullback towards the 90 level or do indeed see new lows, the method which we use to analyze the U.S. Dollar will remain consistent.

So, while no method of analysis is perfect, the consistency of the sentiment analysis that we employ allows us to find actionable setups. Setups that have pre-defined target levels and levels in which we know we are wrong. This takes the guesswork out of the analysis and simply allows us to unemotionally analyze what is in front of us, with no questionable narratives after the fact.