Will the dollar rebound in 2018?

There are no two ways about it: 2017 was a brutal year for U.S. dollar bulls. By mid-December, the world’s reserve currency had fallen against every one of its major rivals on the year, losing a staggering 12% against the euro and nearly 9% versus the British pound (see “Dollar daze,” below).

Incredibly, this move has occurred despite the Federal Reserve being inarguably the most hawkish of the major central banks, hiking interest rates three times, while most of its rivals remained on hold.

So what drove the dollar lower throughout the year? The same thing that always moves markets; an imbalance between buyers and sellers. It seems like a lifetime ago, but as the calendar flipped to 2017, hopes were running high that “Businessman President” Donald Trump would unlock the growth potential of the U.S. economy through a combination of cutting taxes and reducing burdensome regulations. With the help of a Republican-controlled Senate and House of Representatives, traders’ expectations for a pro-business agenda spawned a surge in the greenback and U.S. stocks; the so-called “Trump Trade.”

This view was reflected in the Commodity Futures Trading Commission’s Commitments of Trader (COT) data, which showed that speculative futures traders were holding net-long positions in the U.S. Dollar Index to the tune of over 54,000 contracts at the start of the 2017; the highest net long position in over a year. As President Trump struggled to enact his legislative agenda and the U.S. economy encountered some hurdles, the optimism bubble gradually deflated, and the U.S. dollar fell consistently throughout the first three quarters of the year.

Now, we’re presented with the mirror image scenario from the start of last year: Expectations are low that Republicans on Capitol Hill will be able to get any legislation signed, and dollar index traders are now positioned net short more than 4,000 contracts, the most bearish reading since mid-2014 (see “Cot reversal,” left). In other words, the pendulum of market sentiment has shifted from extreme bullishness with high expectations to extreme bearishness with low expectations, potentially setting the dollar up for a far better year in 2018 than 2017.

Meanwhile, there’s a hawkish shift afoot at the Federal Reserve. Incoming Fed Chair Jerome Powell is unlikely to diverge much from his predecessor Janet Yellen’s cautious outlook, but the annual rotation in voting members definitively favors the hawks. Some of the most dovish voters in 2017, including Chicago Fed President Charles Evans and Minneapolis Fed President Neel Kashkari, will go back to the proverbial bench, making way for two Fed presidents who have shown hawkish tendencies in the past, Loretta Mester (Cleveland) and John Williams (San Francisco). If inflation finally shows signs of perking up in 2018, this group of central bankers won’t hesitate to raise interest rates aggressively to try to ensure the Fed doesn’t fall behind the curve.

With U.S. dollar bulls as downbeat on the prospects for the world reserve currency as they’ve been in years, the bar is low for positive economic surprises. Even if the U.S. economy doesn’t show signs of accelerating in 2018, dollar bears could struggle to push the currency lower given the already-lopsided positioning, especially against currencies that speculators have accumulated heavy long positions in, including the euro, Aussie and Canadian dollar. 

There’s no doubt that buying the greenback requires a leap of faith, but as experienced contrarian traders know, the positions that feel the worst at the start often end up working out the best.  

About the Author

Senior Technical Analyst for FaradayResearch. Matt has actively traded various financial instruments including stocks, options, and forex since 2005. Each day, he creates research reports focusing on technical analysis of the forex, equity, and commodity markets.