Why is the US Dollar under the spotlight again?

Upcoming Economic Events (Singapore Local Time):

Upcoming Economic Events (Singapore Local Time):






ECB Monetary Policy Decision



US Durable Goods Orders (September)



BoJ Interest Rate Decision



US ADP Employment Change (October)



Fed Interest Rate Decision



BoE Interest Rate Decision



US Nonfarm Payrolls (October)

The next two weeks are packed with central bank meetings and interest rate decisions. The Eurodollar market is pricing in a 75bps hike by the Fed in November and potentially another 75bps hike in December.

Markets in Focus

Figure 1 Generic 1st E-mini S&P 500 Index Future (Weekly)

3500 turned out to be a significant technical and psychological support for the S&P 500 index. It is the 50% retracement level of the post-pandemic rally. Unfortunately, the index continued to make lower highs and lower lows in recent weeks, and a proper reversal is not in sight yet.

Figure 2 Generic 1st E-mini Russell 2000 Index Future (Weekly)

The Russell 2000 Index is also sitting at the 50% retracement level. However, the price action looks more constructive than the S&P 500 as a double bottom seems to be forming. The small caps led the big caps in the topping process before the beginning of this year. Could they lead in the bottoming and reversal as well?

Figure 3 S&P 500 vs. Russell 2000 Ratio

The ratio between the S&P 500 and the Russell 2000 further suggests that small caps usually started the selloff months before the big caps, as shown by the ratio exploding higher in early 2020 and late 2021. Afterward, the ratio fell back as the two indices converged, either by the S&P “catching down” with the small caps or the Russell “catching up” with the big caps in recovery. We could potentially see the small caps outperforming the big caps again in the following months.

Figure 4 USD/CHF

The line in the sand for the Swiss Franc is right around parity against the US Dollar. Although this level has rejected further weakening of the Swiss Franc multiple times this year, the upward momentum is gathering. If the recent move in USDJPY is any guide, such artificially held levels can hardly last long in a broad Dollar strengthening environment.

Figure 5 MXN/USD

The Mexican Peso is among the best-performing currencies in the world as it maintained its stability against the raging US Dollar when many other emerging market currencies suffered substantially. However, we wonder how long the Peso can keep strengthening together with the Dollar before something breaks. After all, historically, the MXN/USD pair does have the habit of sudden collapse after consolidating in sideway triangles.

Market Views

In 1971, the former US Treasury Secretary John Connally (1971 – 1972) gave a speech to the other G10 finance ministers in Rome: “The Dollar is our currency, but it’s your problem.” What followed in short order was the rapid devaluation of the US Dollar and the end of Bretton Woods, formally rectified by the Jamaica Accords in 1976.

More than 50 years later today, the macro backdrop is vastly different. However, one thing remains the same. In the face of the rampant and sticky inflation never seen in many decades, countries are once again in the “everyone-for-themselves” mode. Multilateral cooperation has given way to tackling domestic issues. As the Fed steps hard on the brake and steadfastly carries on hawkish tightening policies, the market must, again and again, readjust its expectation of what the terminal rate is likely to be. According to the Eurodollar market, it is currently priced at close to 5% by the end of 2023.

Predictably, this has sent the greenback to a multi-decade high. What is the collateral damage from a strong Dollar and high energy prices? It has pushed many countries into a vicious cycle that is extremely hard to escape. Many emerging market countries have borrowed a large amount of US Dollar-denominated debts in the past decade because of the relatively low and stable interest rates in the US. Many are also energy-importing nations that need the US Dollar to buy oil and gas, their daily essentials. They need to either constantly maintain a current account surplus or sell their foreign reserves in exchange for the US Dollar, to service the debts and pay for energy imports. It means most of them are naturally short the US Dollar. Since the Fed started raising rates this time, it became a double-whammy for these countries as they scrambled for the US Dollar. One of the few options is to sell their US Treasury holdings, which many countries use as foreign reserves. This, unfortunately, further pushed up the entire yield curve in the US, leading to further strengthening of the US Dollar and stress to other countries.

In the past weeks, we have seen extreme market volatility in UK’s Gilt and the Pound. We have also witnessed the Japanese Yen continue to tank to 150, even as the Bank of Japan tried to intervene in both the JGB and the currency markets. These are but two of the largest developed countries by economic size. We fear it is just the beginning, and more is yet to come. The US Dollar is going to be everyone’s problem.

How to play the theme out

A hypothetical investor can consider the following trades1 :

Case Study 1: Short S&P 500 vs. Russell 2000 Ratio

If the investor were to short the S&P 500 vs. Russell 2000 ratio by selling 1 contract of Micro E-mini S&P 500 index future (MESZ2) and buying 2 contracts of Micro E-mini Russell 2000 index future (M2KZ2) at the ratio of 2.14, the spread is notionally hedged. He could set the stop to be above 2.3 and the target at 1.7.

Case Study 2: Short MXN/USD Future

If the investor were to short the MXN/USD future (6MZ2) at 0.049 and set the stop above 0.052, his maximum loss per contract would be (0.052 – 0.049) x 500000 = 1500 USD. An initial target points to 0.4, resulting in (0.049 – 0.04) x 500000 = 4500 USD.

1 Examples cited above are for illustration only and shall not be construed as investment recommendations or advice. They serve as an integral part of a case study to demonstrate fundamental concepts in risk management under given market scenarios.

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