Dollar's Rally from Lows

Key Points:

• Dollar Index rallies after hitting a 3-year low.
• Historical data shows such rallies are usually unsustainable.
• Positive for inflation-related assets; tech and financial sectors underperform.

The Dollar's Recent Rally

In recent weeks, investors have flocked to the dual tightening trade of "stronger dollar + rising U.S. Treasury yields," a capital force that has become the core driver of the dollar's sharp rebound.

This rally occurred after the Dollar Index touched an absolute 3-year low, recording a gain of over 3% in just 42 trading days. On the surface, this appears to be a strong "V-shaped" bottom.According to this, we build a backtest  that the US dollar rebounds from a 3-year low within 42 trading days, and its 30-day rate of change (ROC30) exceeds 3%.

However, after backtesting 14 similar signals since 1978, we found that the dollar struggles to sustain such gains. Data shows that the median yields for the dollar are negative across the short, medium, and long term.

This strongly suggests that the current rise is more likely a countertrend "bear market rally" or "bull trap" rather than the start of a new bull market.Related Backtest Click Here.

The Impact of the Dollar Rally on Other Markets

For the S&P 500 Index, the dollar's failure to sustain its rally is a positive medium-to-long-term sign. Although the short-term probability of gains is low, the index has a high probability of rising over the next three months and one year, with a median one-year return that is also not insignificant.

Gold has delivered the strongest performance among all assets. As the dollar's rise proves temporary, gold has ushered in an excellent risk-reward ratio. One year after the signal trigger, gold's average gain is nearly 5 times its average loss, with a quite appealing six-month return rate.

At the sector level, the core story of this signal seems to be "reflation." Contrary to popular belief, the tech and financial sectors have historically underperformed. The real winners are sectors related to inflation and real assets. 

The energy sector has delivered impressive mid-term win rates, with robust median returns over one year. The materials sector has also performed strongly.

Data on Emerging Markets (EEM) is limited, but the pattern is similar. Short-term weakness gives way to strong long-term returns.

What the Research Tells Us...

The dollar's current rally is a countertrend "bull trap." Similar patterns tend to reverse, leading to dollar weakness in the coming quarters.

Despite the clear historical pattern, this backtest has triggered only 14 signals since 1978. This represents a very small sample size, limiting the statistical robustness of the conclusions. Caution should be exercised when referencing historical data.

Based on historical data, this scenario is positive for risk assets, but not all assets benefit equally. Capital flows indicate a "reflation" trading environment.