Fed Chair Janet Yellen has made it pretty clear, that the Fed is likely to start lifting interest rates this year. Financial commentary about the impending Fed rate hikes generally seems to assume that they will lead to a stronger US Dollar. Certainly, traders in “commodity” economies like Australia; New Zealand and Canada would be thinking this way today. These currencies are all under pressure against the Greenback at the moment, assisted by a rate cut in Canada last night and a news of a weaker than expected inflation print in New Zealand this morning.

The conventional rationale for a bullish $US is based on the view that expectations about changes in interest rate differentials between economies tend to be the key driver for exchange rate moves. The Fed looks likely to lead other major developed economies in lifting interest rates and as this process gets underway, the $US will gain ground against the currencies of those other economies, or so the theory goes.

However, whether this scenario actually plays out might depend on how much is already priced into exchange rates. Markets are s forward looking and the Dollar Index (which measures the US Dollar against a basket of 6 other currencies) is already 23% above the level that kicked off the last major rally in May 2014.

For the US Dollar to keep getting significantly stronger, one of two scenarios may be required

The first might be that the Fed ends up increasing rates faster and by more than markets currently expect. This could widen the interest rate differential between the US and other economies more than currently anticipated and so lead to further Dollar buying.

The second might be that markets are not quite as forward looking as generally thought. As Janet Yellen, said in her speech last week, there is still plenty of room for uncertainty. Slower than expected US growth; low inflation or international risk events may yet derail the Fed’s plans to tighten policy. When the Fed does begin to tighten this uncertainty might be removed, unleashing a major wave of $US buying.

There might also be some circularity in this argument that needs to be considered. A strong $US will dampen US inflation and bear down on the economy by hurting the competiveness of its exports. If the market gets too far ahead of the Fed and the Dollar gets too strong, it might cause the Fed to move more slowly on tightening monetary policy.

The chart outlook supports the case for keeping an open mind and staying flexible about the US Dollar strength.

US Dollar Index Chart

The bullish scenario for the US Dollar Index would be confirmed by a move past the previous high at 100.4. This would require a rally of a 3.2% from the current level of 97.32.  A move well clear of the 78.6% retracement at 98.84 shown on the chart below would be a warning sign that a break to new highs is becoming more likely.

Right now though, this chart is playing out a conventional pattern scenario that could see another leg down in the $US as part of a deeper correction of the whole major rally in the Dollar Index. This scenario would look very much on track if the Dollar rallied a bit further but then peaked about 1-1.5% above current levels. Here it would be peaking around the 78.6% Fibonacci retracement level and at a level where the “cd” swing on the chart below is the same size as the “ab” swing. Both these levels often signify the end of a correction and could set up for another swing lower as suggested by the dashed lines on the chart.

US Dollar Index Daily  Source: Bloomberg US Dollar Index Daily
Source: Bloomberg

Aussie Dollar Chart.

For the Aussie Dollar, the bearish Dollar Index scenario could see it form a base around 72.5- 73.0 and then stage a significant corrective rally. Here it would reject the potential support of the trend line and AB=CD swing pattern shown on the chart below. This would also fit with a further rally of 1-1.5% in the US Dollar index followed by a major decline

AUDUSD cash CFD Daily AUDUSD cash CFD Daily