Why all investors should closely monitor the U.S. Dollar

Key points:

• The price trend for the U.S. Dollar remains favorable and seasonality is also favorable
• Sentiment just flashed an important warning
• Several other little-known indicators recently flashed longer-term warnings for the Dollar

The current favorable trend remains intact

The chart of Invesco DB U.S. Dollar Index Bullish Fund (UUP) shows that the powerful uptrend for the U.S. Dollar remains intact, with price well above a rising 200-day moving average.

Seasonality is confirming this favorable trend. The annual seasonal tendency for the Dollar is now in a favorable period.

The most important thing at the moment is the outsized impact that the Dollar has on other markets, including stocks, bonds, and gold. The table below displays the correlation between UUP and these assets over the past five years versus the correlation over just the last six months. Note the increase in inverse correlation recently. Bottom line: As the Dollar goes, many other things do the opposite.

Some reasons to expect a Dollar reversal in the months ahead

Our Optimism Index (Optix) indicator recently flashed an important warning regarding the Dollar in the year ahead. The chart and table below highlight those times when the 50-day Dollar Optix dropped below 0.72.

The sample size is small, but results during the six months after a signal are essentially a coin flip, while all four previous signals saw the Dollar lower 12 months later.

Currency risk reversals have also sounded the alarm

As highlighted in this article, the British Pound risk reversal recently reached an extreme. The chart below displays those rare occasions when the British Pound risk reversal crossed below -3.2 for the first time in six months and the subsequent performance of the U.S. Dollar.

We can see similar behavior among traders in Canadian dollar options. Once again, the caveat regarding the small sample size applies. Nevertheless, the results following previous signals have been overwhelmingly unfavorable for the Dollar.

What the research tells us…

Markets often go to extremes. The U.S. Dollar has marched relentlessly higher since bottoming out in May 2021. With seasonality presently favorable and a bullish price trend intact, the potential for the Dollar to push sharply higher remains for the time being. But a confluence of indicators suggests that once this advance runs its course, the Dollar will be due for a sharp break. Such a break would likely have significant implications for investors in stocks, bonds, and gold.