USD Index – risk of correction to 92.00-91.50 levels in short-term

The US dollar has rallied now for more than 7-months due to safe haven appeal, strong domestic economy and a race for looser monetary policies across Asia and Europe amid falling energy prices.

Over the past seven months, the USD index has hardly seen a noteworthy correction as the bulls were regularly recharged by the rout in oil prices, monetary stimulus in Japan and Eurozone and increased probability of interest rate hike in the US due to strong labor market performance.

The rally was largely driven by non-US factors -

• Sharp fall in EUR – The speculations of the sovereign QE program, coupled with negative rates, ABS program and LTRO program drove EUR/USD to a decade low of 1.15 from the 1.39 seen in April 2014.

• Sharp fall in Yen – The Bank of Japan’s surprise expansion of the monetary stimulus program on Oct. 31st, 2014 led to a sharp rise in the USD/JPY pair to 120.00 levels.

• Fall in Commodity backed currencies – Weaker energy prices pushed the prices of other commodity prices lower, leading to a sharp fall in the commodity backed currencies like the AUD and the CAD.

• Fall in GBP – The fall in GBP/USD from the high of 1.72 was largely driven by Scotland referendum, followed by the threat of deflation and a dovish turn by Bank of England policymakers amid the race to looser monetary policy across Europe.

Consequently, the US Treasury yields remained relatively resilient compared to their European and Asian counterparts. However, all of the non-US factors may have been fully priced-in by markets at least in the short-run. Hence a further rally in the USD index depends on Federal Reserve’s timing of the first interest rate hike.

The USD index, thus, appears due for a correction as –

• The ECB may under deliver – The expectations from the European Central bank has already pushed benchmark yields across most of the Europe to near zero levels. Furthermore, the EUR is already at multi-year lows against major currencies. Thus, the ECB may wait till March before going ahead with sovereign bond purchases. In such a case, the EUR/USD is at a risk of sharp reversal.

• Bank of Japan holds fire – The Bank of Japan refrained from expanding its monetary stimulus program today, leading to rise in the Japanese Yen. Given the sharp depreciation in the Yen, the Bank is unlikely to expand its QEE in the short-term. Moreover, falling inflation expectation is unlikely to push the bank towards more QQE as weak energy prices are widely expected to be net positive.

• Fall in Pound overdone – Though Bank of England minutes released today indicates a unanimous vote for maintaining interest rates at record lows, the bank still appears relatively hawkish when compared to its other European and Asian peers.Furthermore, the BOE is optimistic about the economic growth, while the Gilt yields appear to have priced-in the disinflationary pressures. Thus, the GBP/USD pair appears more likely to recover in the short-run.

• Fed may delay interest rate hike – the interest rate futures market in the US now sees the rate hike happening not before September 2015. Meanwhile, the probability of a delay in the interest rate hike in the US shall increase as the multinationals in the US feel the heat of a strong USD. The weak Q4 results are likely to push rate hike far out in 2015 or early 2016. Similarly, competitive devaluation of currencies across US and Asia may force the Fed to delay the rate hike.

To conclude

• The USD index is likely to test 92-91.50 levels in the short-term

• The rally is at risk of delay in the US interest rate hike

• Non-USfactors behind the rally appear to have been priced-in at least for the short-term

• The index is overbought as per technical indicators. The daily RSI and price chart reveal a negative divergence.

• The index risks rallying to 94.50 levels in case of a surprisingly big stimulus program from the ECB and a more hawkish stance from the Federal Reserve.