Since last week’s FOMC meeting, there has been a significant shift in the outlook on major forex markets. How the US dollar (USD) is viewed by traders has changed. With the Federal Reserve loading the starting gun on its tightening cycle, USD can no longer be viewed alongside the Japanese yen as the laggards of major forex. This means the views on how to trade USD pairs will need to be tweaked.   

  • Short-covering of USD positioning has been the driver of the near term USD rally

  • USD will be unlikely to sustain upside momentum unless US Treasury yields continue to rise

  • The sharp decline in EUR/USD and GBP/USD will now be a chance to play a range

  • The USD rally is another chance to sell USD/CAD

 

A short covering USD rally

The short USD trade has been a key feature of forex trading in recent months. However, suddenly the market has needed to re-assess this view. The potential for tapering $120bn of monthly asset purchases could be later this year, whilst an interest rate rise in 2022 is now a possibility too.

Subsequently, the big short USD positioning will see some reversal. The weekly CFTC forex futures data showed that before the Fed decision the market was a sizable (-$18.3bn) net sellers of USD. This position has some way to unwind and will be interesting to see how much it has when the data is released.

Chart, histogram Description automatically generated

This unwinding of net short USD positions will have been a key factor in driving the USD rally.

 

To continue the USD rally the 10 year Treasury yield needs to rise  

However, we still believe that this USD rally will be short term. The Federal Reserve dot plot is only catching up with what the market had already been pricing on Fed Funds futures. But for USD to sustainably move higher, then the US 10 year yield will need to move decisively higher, and/or inflation expectations move decisively lower. 

For now, although inflation expectations have moved slightly lower (the prospect of higher interest rates should drag inflation lower), this move is by no means decisive.

UST yields and inflation expectations

For sustainable USD strength, “real” yields need to continue to move decisively higher.

USD and real bond yields

So, for now, whilst there may be some further legs in this USD move, we do not expect it to be a sustainable rally and that it will turn into either a ranging move against some currencies or another chance to sell against others.

 

Looking for ranging markets on EUR/USD and GBP/USD

The EUR and GBP can no longer be considered to be outperformers of USD. 

  • For EUR, the ECB is still dovish in its outlook for monetary policy (compared to a less dovish Fed).

  • For GBP, the UK is experiencing concerns over the Delta variant of COVID and there is a pick up in Brexit risk as trade relations with the EU remain on edge.

Therefore, the re-pricing of USD in the past week seems to be a reflection of what we now see as a more ranging outlook for EUR/USD and GBP/USD.

Looking at the technicals, EUR/USD has picked up from 1.1845 but there is still the potential for further downside into the 1.17/1.18 support band. However, we would see this as range lows and a buying opportunity. For the bulls to regain control within the range now, there needs to be a move through 1.1950/1.2000 mid-range resistance. 

EURUSD technical analysis

On GBP/USD the corrective move has broken the primary uptrend and momentum has broken its bullish configuration. We see 1.3670/1.3800 as a support band now for a trading range between 1.3670/1.4240. We are buyers around 1.3670/1.3800 up towards 1.4000 which is now a mid-range pivot.

GBPUSD technical analysis

 

We still see USD/CAD as a sell into the USD strength

We believe that USD/CAD is the one major pair to use this USD rally as a significant opportunity. We still believe that the Bank of Canada is ahead of the Fed in its tightening cycle and this will help to fuel further CAD outperformance of USD (driving USD/CAD lower).

Technically, USD/CAD rallies have consistently been sold into for several months. This swing higher is now into a key zone of resistance 1.2365/1.2590 which we believe is an area to look for the next selling opportunities for a move back towards 1.2000 in due course.

USDCAD technical analysis

  

Conclusion

The USD rally has changed the outlook on several major forex pairs. We see this rally on USD could still have some further room to run, but we believe that trading opportunities from this move are close.