- The dollar (via the DXY index) plunged ahead of the January U.S. NFP report, erasing all gains made around the January Fed meeting.
- With the likelihood of a Fed rate hike remaining high, the dollar has been surprisingly resilient against the yen in the face of broader dollar weakness and declining U.S. equities.
- The IG Client Sentiment Index indicates a mix bias in USD/JPY in the short term.
Last week's gains disappeared, and then some
It has been an absolutely brutal week for the dollar. The DXY index wiped out all of last week's gains around the Fed's January meeting for two main reasons. First, expectations for the U.S. jobs report deteriorated rapidly after the release of the January ADP report. Second, a surprising shift to a higher ECB this year gave a big boost to the euro, which is the largest component of the DXY index (57.6% weighting).
As a result, the dollar is in a bind: the weak US NFP report has been mostly digested, but with US inflation still at a 40-year high, it seems unlikely that the Fed will remove its aggressively hawkish course. Tomorrow's U.S. NFP report could trigger an exhaustive sell-off, which would allow the dollar to stabilize soon thereafter. In particular, the USD/JPY exchange rate could easily be in the best position among major dollar pairs if the greenback is able to rise.
Hawkish Fed still in the picture
We can gauge whether the Fed rate hike is being priced using Eurodollar contracts by examining the difference in borrowing costs for commercial banks over a specific time horizon in the future. The following K-line chart1 shows the difference in borrowing costs (spreads) between the February 2022 and December 2023 contracts to gauge the direction of interest rates through December 2023.
EURUSD futures contract spreads (February 2022 to December 2023) [BLUE]US 2s5s10s butterfly [ORANGE]DXY index [RED]: daily schedule (August 2021 to February 2022) (Chart 1)
By comparing the odds of a Fed rate hike to the U.S. Treasury 2 May 10 butterfly move, we can determine if the bond market is behaving in a manner consistent with 2013/2014 when the Fed hinted at its intention to taper its quantitative easing program. The 2s5s10s butterfly measures a non-parallel shift in the U.S. yield curve, which, if history is accurate, implies that intermediate rates should rise faster than short-term or long-term rates.
By the end of 2023, the rise is 162 bps (6 up plus 25 bps), just off cycle highs, while the 2s5s10s butterfly spread remains near the levels of late December and late January. The disconnect seen in recent days may be a function of the market pricing in a weak January U.S. NFP report, which was expected to be revised down sharply after the January U.S. ADP Employment Change report earlier this week showed job losses of -301,000 jobs. The likelihood of a contraction in the January U.S. NFP data has increased; however, the Bloomberg News consensus forecast remains at +150K.
DXY Price Index Technical Analysis: Daily Timeframe (January 2021 – February 2022) (K-line chart 2)
All of last week's gains in the DXY Index have been erased and the dollar indicator is now on track to close below its daily 21 SMA (one-month moving average) for the second time in a row, for the first time since late December. This week's decline led the DXY Index down at the confluence of Fibonacci levels: the 50% retracement of the 2017 high/2018 low range at 96.04; and the 23.6% retracement of the 2011 low/2017 high range at 96.48.
A deeper setback could occur before a low is found. Trendline support from the May 2021 and January 2022 swing lows up was near 95.15 at the end of the week, while the 2022 low fell to around 94.63 – just as the March 2020 low, September 2020 high and September to early November 2021 high had formed. With the likelihood of a Fed rate hike unchanged, the area around 94.63 may represent an opportunistic risk/reward level to seek long opportunities again.
Technical analysis of the USD/JPY exchange rate: daily time frame (January 2020 to February 2022) (K-line chart 3)
While the DXY index has been struggling, the USD/JPY exchange rate has proven to be incredibly resilient. The sideways movement that began in October continues. The situation remains that "concessions between U.S. Treasury yields and U.S. equities are the main cause of this turbulence, and this dance is unlikely to end anytime soon. As such, a rally above 116.00 could be seen as an opportunity to sell range/channel resistance, while a break below 113.50 could be seen as an opportunity to buy near-term range/channel support." Eventually, a symmetrical triangle could form since late November, where it would seek higher resolution in the previous move.
IG Client Sentiment Index: USD/JPY Exchange Rate Forecast (February 3, 2022) (Chart 4)
USD/JPY: Retail data shows that 38.62% of traders are net long and the ratio of short to long is 1.59:1. The number of net longs decreased by 7.90% from yesterday and increased by 0.55% from last week, while the number of net short traders decreased by 2.57% from yesterday and decreased by 10.02% from last week.
We usually take a counter-trend view of market sentiment and the fact that traders are net short suggests that USD/JPY prices are likely to continue to rise.
Positions are more net short than yesterday, but less net short than last week. The combination of current sentiment and recent changes complicates our trading preferences for USD/JPY.
– By Christopher Vecchio, CFA, Senior Strategist