Currencies – The Dollar Has Reasons To Rally To Higher Highs – Invesco DB USD Bullish ETF (NYSEARCA:UUP)

The dollar index should be trading at a higher level, but it is not. The dollar is the reserve currency of the world; it is the foreign exchange instruments that central banks, monetary authorities, and governments all over the world hold. The US dollar is also the benchmark pricing mechanism for almost all commodities, which are global assets.

The dollar index, which measures the US currency against the world’s other leading foreign exchange instruments, reached a peak in early 2017 at 103.815 on the active month futures contract. A correction followed taking the greenback index to a low at 88.15 in February 2018 just thirteen months later. Since then, the dollar index has been moving to the upside slowly, making higher lows and higher highs, reaching its most recent peak last month. The dollar has a lot going for it these days, and for those who do not trade futures or in the highly liquid over-the-counter currency market, the Invesco DB US Dollar Index Bullish Fund (UUP) and its bearish counterpart (UDN) provide an alternative for market participants looking to position on the long or short side of the dollar index.

A new high in the dollar index in April

After reaching a high at 97.705 on the nearby dollar index futures contract in mid-December 2018, the index remained below that level until it finally reached a new peak in April.

Source: CQG

As the daily chart highlights, the dollar index rose to a higher high at 98.085 during the week of April 22. The ascent of the dollar against the other leading world currencies has been slow and steady. In a sign that another new and higher high could be on the horizon in the near future, the index was trading at the 97.775 level last Friday, which was just below the most recent peak.

Moreover, the dollar index put in a bullish key reversal trading pattern on the weekly chart last week. The index fell to a low that was lower than the previous week and closed above the prior week’s high. The technical pattern could send the dollar to another higher high, which would have consequences for commodities prices and markets across other asset classes. The rise in the dollar should come as no surprise as fundamentals when it comes to interest rates support a higher greenback.

Interest rate differentials support the dollar

One of the most significant factors when it comes to the path of least resistance of a currency is the level of interest rates compared to other foreign exchange instruments. The euro currency comprises 57% of the dollar index, and the index also has exposure to the Japanese yen. Short-term interest rates in the euro and the yen remain in negative territory with the euro charging 40 basis points for holders of the currency. Meanwhile, the short-term yield on the US dollar or the Fed Funds rate stands at 2.25-2.50% making the yield differential between the US and European foreign exchange instruments, which are both reserve currencies, 2.65-2.90%. The yield differential is a compelling factor that favors a higher dollar compared to the euro currency. With short-term rates on the yen also in negative territory, the dollar provides a significant yield advantage compared to the Japanese currency. The bottom line is that capital grows for those that hold dollars by over 2% per annum, while it shrinks for those who hold the euro or the yen.

Trade issues with China push the dollar higher

The recent escalation of the trade dispute between the US and China is inherently bullish for the dollar. China has suffered economically under the weight of tariffs on their exports to the US, which is the leading consumer market in the world. The price of protectionism for China is higher than it is for the US. The Chinese have battled the economic slowdown by devaluing their currency, the yuan and slashing domestic interest rates to stimulate borrowing and spending and inhibit saving. A lower yuan versus the dollar boosts the value of the dollar against not only the Chinese currency, by against other world foreign exchange instruments.

The US economy is healthy

Under the Trump administration, tax and regulatory reforms have ignited economic growth. Even though the Fed hikes rates by four times in 2018, GDP growth remains robust, and unemployment is at the lowest level since the 1960s as the labor market continues to tighten. The latest data at the end of last week showed that housing starts increased to an annual rate of 1.24 million in April, which was above consensus estimates at 1.21 million. At the same time, the Philadelphia Fed manufacturing index in May rose to a four-month high at 16.6 after coming in at 8.5 in April.

The rise in interest rates last year and the trade dispute with China has not stopped economic growth in the US which continues to reflect the fiscal stimulus from changes to the corporate tax code and the regulatory environment which have supported business.

The only issue is the administration’s dollar policy – UUP and UDN

Fundamentals support a strong dollar, and we could see a higher high in the dollar index as soon as this week. Last week’s bullish reversal could be all the dollar index needs to push to a new level on the upside 2017 as the index is on a path towards the 100 level.

Meanwhile, past administrations in the US had followed a strong dollar policy, but President Trump and his Treasury Secretary Steve Mnuchin have made no secret of their desire for a weaker US currency as a strong dollar makes US exports less competitive in global markets. Moreover, a weaker dollar is an effective tool in the ongoing trade dispute with the Chinese when it comes to competition for exports around the globe. It is possible that the US treasury will intervene in the foreign exchange market to prevent the dollar from running away on the upside over the coming days and weeks given the most recent price action in the currency market.

The most direct route for a trade or investment position in the dollar on the long or short side of the market is via the highly liquid over-the-counter foreign exchange market or the futures contracts on currency pairs and the dollar index. For those who do not venture into either of those arenas, the Invesco DB US Dollar Index Bullish Fund and its bearish counterpart provide an alternative. The fund summary for UUP states:

The investment seeks to establish long positions in ICE U.S. Dollar Index futures contracts with a view to tracking the changes, whether positive or negative, in the level of the Deutsche Bank Long USD Currency Portfolio Index – Excess Return over time, plus the excess, if any, of the sum of the fund’s Treasury Income, Money Market Income and T-Bill ETF Income over the expenses of the fund. The fund invests in futures contracts in an attempt to track its index. The index is calculated to reflect the changes in market value over time, whether positive or negative, of long positions in DX Contracts.

The most recent top holdings in UUP include:

Source: Yahoo Finance

UUP holds dollar index futures contracts, so it does an excellent job replicating the price performance in the futures market. UUP has net assets of $387.13 million and trades an average of just over 500,000 shares each day. The inverse product UDN has net assets of $33.05 million and trades around 30,000 shares each day.

The path of least resistance for the dollar remains higher and last week’s technical action points to another higher high in the greenback. The only thing standing in front of continued strength in the US currency is the government that prints the legal tender which is likely to stand in front of an explosive move in the interest of stability in the foreign exchange market and as a tool when it comes to trade.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author always has positions in commodities markets in futures, options, ETF/ETN products, and commodity equities. These long and short positions tend to change on an intraday basis.

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