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  • It’s been a rough end to what would otherwise have been an excellent week for the US dollar.
  • After soft NFP data, the DXY has fallen all the way back to the key 91.00 level.

It’s been a rough end to what would otherwise have been an excellent week for the US dollar; having started the week just above the 90.50 mark, the Dollar Index (DXY) had rallied as high as 91.60 by the start of Friday’s Asia Pacific session, a rally of more than 1% at the time. Since Friday’s downbeat January labour market report, half of these on the week gains have gone, and the DXY is looking precarious sat just above the 91.00 handle.

USD thoughts

Friday’s price action suggests that much of this week’s rally was driven by hopes for a strong NFP report. Strong ISM Manufacturing and Services PMI reports (on Monday and Wednesday), combined with a stronger than forecast ADP National Employment number seemed to boost expectations that the headline NFP number would be closer to 200 or 300K, as opposed to expectations at the start of the week for something closer to 50K. Of course, when the NFP proceeded to underwhelm, this USD strength needed to be priced out, hence Friday’s drop.

Reading between the lines a little, this week’s price action suggests a shift in the psychology of USD markets; in weeks gone bye (like when USD was getting slammed day in day out in the fourth quarter of 2020), the market conditions that have been seen this week (strong equities, commodities etc.) would have likely weighed on USD, given its status as a safe haven asset. But the mood has changed, and markets don’t appear to be treating USD in quite the same safe haven way as before. Prior to Friday, USD had spent near enough the entire week rallying in tandem with US equities!

Perhaps this says something about what is and is not driving markets right now; stimulus optimism has been the name of the game this week, as the US Congress looks ever more likely to deliver a meaty spending package that will further boost US economic activity and propel US economic outperformance versus its developed market peers. Stimulus driven higher US economic growth boosts US equities (they can expect higher earnings, thus higher valuations), boosts commodities (given higher US demand) and (here is the key) might well result in the Fed tightening monetary policy before the likes of the ECB, BoE, BoC, BoJ and other major developed market central banks. If stocks and commodity markets had been rallying this week on the back of expectations for ongoing central bank support, the USD would certainly not be rallying also, that much is for sure!

In that sense then, does it really matter if January was a little weaker than anticipated for the US labour market? After all, a weaker January doesn’t change the outlook for fiscal policy, which will be the main driver of US growth in the coming years. If anything, it might strengthen the sense of urgency felt by Congress to “go big” (as US President Joe Biden and Treasury Secretary Janet Yellen have been urging). This might end up boosting growth even more and resulting in even greater US outperformance and USD favourable central bank divergence.

The above thinking would suggest that USD’s sell-off on Friday is a tad overdone. Or maybe, the above is all just a case of overthinking. The US dollar has been long overdue a bit of a short-squeeze for quite some time. Perhaps that all this week’s price action was, just some of the weaker shorts getting out. And perhaps soft data on Friday was just used as an excuse by those wanting to add to shorts to get in again.

Indeed, the arguments for the US dollar to continue heading lower are still fairly strong; all this incoming stimulus is (for the most part) going to be soaked up by the Fed, meaning continued USD money supply expansion, and all of this will likely further widen the US’ trade deficit, adding to what is already a powerful structural impediment to USD strength. Meanwhile, if vaccines work and the global economy comes back roaring in the second half of 2021, this should be a great thing for risk assets, which, if the USD is still looked at as a safe haven, ought to be a bad thing for the buck.

In the short-run, much might depend on whether the DXY can hold above the 91.00 between now and Friday’s FX market close at 22:00GMT; a close below could be seen as a bearish signal that might embolden some of the long-term USD bears to add to their short positions, potentially weighing further on the currency at the start of next week. If DXY holds above the 91.00 mark (as it currently looks as though it will), this might be seen as “confirmation” that this week’s rally hasn’t just been a dead cat bounce or flush out of weak shorts, and might actually be “for real”. In which case, a move back towards this week’s highs above 91.50 over the course of next week would seem likely.

DXY key levels