3 Reasons Why Bounce In U.S. Dollar Is (Finally) Due – PowerShares DB USD Bull ETF (NYSEARCA:UUP)

It has no doubt been an onslaught for the U.S. dollar (UUP) with the DXY (U.S. Dollar Index) down roughly 10% YTD and back to levels last seen in 2015. Relief rallies have been few and far in between with the DXY persistently below the 50DMA since April.

Numerous factors have contributed to and compounded the U.S. dollar’s weakness, most notably the turmoil in Trump’s administration and slowdown in the U.S. economy early in the year. On top of that, the tail risk in the euro (FXE) has diminished while economic data has continued to surprise to the upside in Europe, prompting expectations of QE taper by the ECB as soon as next month, all of which have led to the surge in the euro vs. the USD in 2017. That being said, there are compelling reasons to expect a meaningful bounce in the U.S. dollar in the coming months:

1. Stabilizing Trump Approval Rating

Since inauguration, President Trump’s approval rating has been on a steady, almost one-way decline similar to the one in the U.S. Dollar Index. That being said, after bottoming in the middle of August when he made his controversial speech on the racist violence in Charlottesville, Va., Trump’s approval rating has actually stabilized and rebounded since. According to the NPR, “An NBC News/Wall Street Journal poll out Thursday found Trump’s approval at 43 percent, up 3 points from the month before,” with Trump working with Democrats being the catalyst as “the poll found that 71 percent approved of Trump’s move.”

As shown above, Trump’s weighted average approval rating, courtesy of FiveThirtyEight, has moved mostly in line with the U.S. Dollar Index until Trump’s approval rating started rebounding and diverging from the dollar this month. Further improvements in Trump’s approval rating will likely hinge on the success of his tax plan, which aims to reduce the corporate tax rate to 20 or 15 percent, and cut the top individual tax rate to 35 percent down from 39.6 percent. According to Bloomberg:

Trump plans a trip to Indiana Wednesday for a speech on tax issues, a person familiar with the planning said. The White House and congressional Republican leaders are preparing for a push for tax legislation that follows a series of defeats since Trump’s inauguration, including their failure so far to repeal Obamacare.

While the devil remains in the details, fulfilling one of Trump’s major campaign pledges would most certainly aid the recovery in Trump’s approval rating as well as the U.S. dollar.

2. Pick Up in Economic Data

A slowing U.S. economy in the first quarter of 2017 certainly contributed to the weakness in the U.S. dollar, though it has since picked up with Q2 growth at the fastest pace in 2 years. Indeed, the Citigroup Economic Surprise Index has troughed middle of the year and has been recovering higher back towards the zero line.

While Hurricane Harvey and Irma have certainly dented Q3 growth, their negative impact will most likely be transitionary and offset in later quarters. One of the key leading indicators to watch is the 5-year forward inflation expectation, which has likewise bottomed since the middle of 2017 and been hovering near the Fed’s inflation target of 2%. Absent an unforeseen collapse in inflation expectations, we expect Yellen and the Fed to keep their hawkish stance in September’s meeting going forward which would certainly give the U.S. dollar a boost.

3. Overstretched Euro

The euro, which makes up almost 60% of the U.S. Dollar Index, has enjoyed a relentless rally all year thanks to positive surprises in economic data and a hawkish tone from the ECB. It has also resulted in the largest build-up of speculative long positioning in euro futures since 2011 based on the Commitment of Traders report. An unwind of similarly large bullish positioning in the euro the last two times led to major reversals in the EUR/USD, as shown below:

In terms of catalysts, aside from factors mentioned above which would strengthen the dollar, the next focal point will be Draghi’s decision in the upcoming October ECB meeting on the timing and pace to taper QE. We believe that much of the expectations for the ECB to taper QE at some point have already been priced in, and therefore hurdles will be high for the euro to make further gains absent an unexpectedly hawkish tone. Though, that is turning more unlikely based on the latest divisiveness among ECB policymakers due to “a stubbornly strong euro, with its dampening effect on inflation”. Per Reuters:

This is raising the likelihood that they will seek a compromise solution on Oct. 26, whereby any end-date for purchases would not be set in stone, or that they will put off part of the decision until December, the sources added.

Even in the scenario that the ECB does announce the decision to taper QE as soon as next month, if history is any guide, when then-Fed chairman Ben Bernanke hinted at tapering QE in May 2013, the U.S. dollar actually peaked shortly after and continued pulling back into and six months after the announcement of QE taper. Therefore in the short-term, we expect the euro to correct, especially with the reversal of lopsidedly long speculative positions providing extra tailwind.

To sum up, we expect a strong bounce in the U.S. dollar in the coming months based on the aforementioned factors, even though the long-term outlook remains murky. In the DXY, we target a retest of the 100-day moving average which stands at 95 and roughly 3% from a current price point of 92. For EUR/USD, we are looking at a pullback towards 1.15 area, which is the breakout area from a 3-year consolidation as well as the 100-day moving average.

Similarly, we expect the yen to continue its recent decline vs. the U.S. dollar with a target of 115 in the USD/JPY (FXY). Given their correlation, gold (GLD) and Treasuries (TLT) would most certainly pullback alongside as well.

For equities, we remain constructive on European markets (FEZ) in spite of the expectation of a pullback in the euro, as discussed in another recent piece on Seeking Alpha.

Why New Highs Are Coming For European Stocks, Even If ECB Tapers QE

To conclude, a rebound in the U.S. dollar is finally due after the YTD onslaught and we will reevaluate how it plays out towards the end of the year.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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