Volatility In the Dollar Index

The US dollar is the world’s reserve currency, meaning it is the foreign exchange instrument favored by central banks and governments worldwide. Reserve currency status is a function of economic and political stability. The United States remains the world’s leading economy in early 2022, but China is nipping on its heels. 

Meanwhile, a reserve currency must be fully convertible to other foreign exchange instruments making it a highly liquid financial asset. The dollar continues to have that advantage over the Chinese yuan. 

The dollar tends to be the currency that market participants use during uncertainty and turmoil. In March 2020, as the global pandemic gripped markets across all asset classes, the dollar index rose to 103.96, the highest level since 2002. After making a slightly higher high than the 2017 103.815 peak, the dollar turned lower and fell to a low of 89.165 in January 2021 as the US Federal Reserve slashed the Fed Funds Rate to zero and instituted a quantitative easing program to put a cap on rates further out along the yield curve. The dollar index made a higher low in early 2021 as it reached a low that was above the early 2018 88.15 bottom. 

After reaching the January 2021, the dollar index has been in a bullish trend, with the latest high in January 2022. 

Higher lows and higher highs in the dollar index

Over the past thirteen months, the dollar’s ascent has been slow and steady. 

The chart highlights the rise from 89.165 on January 6, 2021, to the most recent high at 97.44 on January 28, 2022. The index mostly made higher lows and higher highs, breaking out of a bearish trend in August when it moved above the late March 93.47 high. 

While the dollar index corrected from the 97.44 and was at the 95.635 level on February 8, it remains above the first technical support level at 94.61, the January 14 low. 

Rising US interest rates typically support the dollar

There is no longer a question of if US interest rates will increase in 2022, but how much they will rise. The Fed will increase the short-term Fed Funds Rate by 25 or 50 basis points at the March FOMC meeting. Bank of America projects the central bank will increase the rate seven times this year, pushing the Fed Funds Rate to the 1.75% level by the end of 2022. 

Meanwhile, quantitative easing is winding down, and asset purchases will end in early March. Consumer and producer price indices, GDP growth, and the latest jobs data support a hawkish approach to monetary policy. The Fed will likely move from quantitative easing to tightening, allowing maturing debt securities to roll off its swollen balance sheet. 

The central bank conducts monetary policy through the short-term Fed Funds Rate while the bond market establishes rates further out along the yield curve. Quantitative tightening could put upward pressure on medium and long-term government debt security yields, but the bond futures market has already reacted. 

The US 30-Year Treasury bond futures chart illustrates the bearish price action. The long bond futures already fell below the first support level at the March 2021 153-29 low. The next downside target was at 152-28, the July 2019 low, which gave way on February 8 and could be a gateway to a move to the 2018 136-16 bottom. 

The path of least resistance of US interest rates is higher, and higher rates support a stronger US dollar. 

2022 is no ordinary year

While the Fed is ready to combat rising inflation with monetary policy tools, 2022 is anything but a typical year. The following issues show the Fed is fighting an uphill battle, and rates may not rise fast enough to stem inflation, leading the dollar index to slow or stop its ascent.

• Bank of America’s forecast was an outlier at first. However, with core CPI at 5.50, the Fed Funds rate would need to rise by 25 basis points 23 times to push real interest rates into positive territory if inflation remains at the current level. Negative interest rates are not bullish for fiat currencies, and the US dollar is no exception. 
• The US debt rose above the $30 trillion level on a one-way street higher. Rising debt weighs on the faith and credit of the US government, which are the factors that determine a fiat currency’s value.
• Geopolitical tensions with Russia and China are mounting over Ukraine and Taiwan. North Korea continues to test-fire rockets capable of carrying nuclear weapons, and Iran is enriching uranium, each day coming closer to possessing an atomic bomb. Geopolitical problems can cause significant volatility in the currency markets over the coming weeks and months. 
• The price of crude oil is on an express train to the $100 per barrel level. While the world is moving to address climate change, fossil fuels continue to power lives and businesses. Rising crude oil is inflationary fuel. With the pricing power passing from the US to OPEC+, monetary policy tightening, and US strategic petroleum stockpile releases may not stem the ascent of crude oil’s price. 
• China is preparing to release a digital yuan. As the Chinese economy overtakes the US economy over the coming years, the Chinese yuan could challenge the US dollar for reserve status.

The current environment poses challenges for markets across all asset classes. While rising interest rates are historically bullish for the US dollar, other factors could outweigh the rising yield. 

The dollar’s position is in jeopardy as China rises and cements ties with Russia

The winter Olympics began last weekend, but the top story does not come from the sports venues where athletes compete for medals. US officials are boycotting the games because of China’s human rights abuses. However, Russian President Vladimir Putin was on the scene, and he met with Chinese President Xi. In a snub and dangerous warning to the US and Europe, the Chinese pledged support for Russia regarding Ukraine, and Russia did the same regarding Taiwan. 

The US and Europe consider Ukraine free Eastern Europe, while President Putin believes Ukraine is Western Russia. China has long stated its intention to reunify with Taiwan, which the Democratic nation rejects. The potential for hot or cold wars on two fronts has not been this high in decades. The rising threat of military hostilities could cause substantial market volatility across all asset classes, and currencies are no exception. 

The trend remains bullish- Levels to watch in the dollar index

The long-term trend in the US dollar index remains higher as of February 8, 2022. 

The chart shows the pattern of higher lows and higher highs since the April 2008 71.05 low. The first level of technical support is at the January 2021 89.176 low. Just under there, a move below the February 2018 88.150 low could unleash a bearish technical firestorm in the dollar index.

On the upside, technical resistance is at the March 2020 103.96 high, the highest level since 2002. A move over that level could cause a substantial technical rally. 

Many issues face markets in early 2022. While currencies tend to display far less volatility than other assets, the potential for elevated price variance in the fiat currencies is high as the full faith and credit of the governments that issue the legal tender is declining.