Is the reign of the US dollar over? Since January, the US dollar has not been driven by Fed hike expectations.
The fast and strong US dollar strengthening in 2014 and 2015 can be attributed to expectations of the Fed embarking on a tightening cycle. At the time, investors also believed divergence was possible, that is to say that the US economy could grow independently at over 3% YoY while the rest of the world was still recovering and in easing mode.
At the start of this year, we were quite surprised by the increasing gap between the US trade-weighted index and the dollar index: one kept increasing as EM and commodity-linked currencies kept being hit, while the other one remained surprisingly range-bound.
Looking more closely at the dollar index and market expectations over the Fed tightening cycle give interesting results.
We conclude that the DXY has not been driven by Fed hike expectations since the start of the market rally.
All in all, we should not see a strong and fast strengthening of the US dollar against the majors like in the past, at least this year, but believe that the dollar has reached a bottom. However, even if the Fed starts being more hawkish, probably triggering a re-coupling of the US dollar and Fed expectations, keep in mind that the markets are already pricing in a very shallow tightening path, with a recession expected to happen within the next two years. The dollar index should remain range-bound for now in an environment prone to some bouts of volatility.
With above aspects, by now you can probably guess why DXY index is drifting in a range bounded trend (see technical charts) with the upper limit of 100.51 and lower limit of 92.62 from last 15 months or so.
Option traders taking on the U.S. dollar index have a secret weapon in the VIX, an index of expected future price volatility that's often called the “fear index.” When the VIX is running high, the markets are choppy and risky for investors.
In a period of high VIX numbers and widespread negative sentiment on the U.S. markets and dollar, you can leverage the fear and uncertainty into a strong play on the dollar-index option. Simply buying put options is the easiest way to go; the downside risk, again, is limited.
