EURUSD finally broke down, meaning DXY finally broke out.  We set the 1.0999 target over two months ago, reasoning that a breakdown in equities would send the dollar higher and the EURUSD lower. The DXY broke out two days later – even though the equity correction was delayed by year-end equity-propping silliness that saw DXY stuck in a holding pattern for over two months.

Since the US is a net importer, the value of the USD is an important tool in the Fed’s inflation fighting toolkit.  All evidence to the contrary, the Fed insists they actually care about inflation.  We’ll take a fresh look at the currencies this morning to see what they suggest about inflation and the overall markets.

continued for members…

The bigger picture for EURUSD. It’s made a huge move over the past year, with more to come according to the charts. Does the economy agree?

The value of the dollar has been very negatively correlated with oil prices forever. Since oil is priced in USD, the higher the dollar goes the cheaper oil usually is.

Oil’s crash in early 2020 was mirrored by a huge spike in the USD as money came pouring in from secondary currencies and equities to the safety of the dollar.As oil prices recovered, so did stocks. And, the USD dutifully began dropping – very substantially.  With the Fed behind the stock market, DXY became an attractive candidate for a carry trade: borrow dollars to invest in stocks, eventually selling them at a (guaranteed) profit and paying off the debt with depreciated dollars.

The continuing decline in DXY may have helped stocks, but it greatly exacerbated inflation as YoY oil price gains soared to over 60%. The chart below shows gas prices, but the WTI chart is very similar.

The Fed fell woefully behind the curve – choosing stock market gains over controlling inflation and, therefore, investors over ordinary Americans on fixed incomes (but, that’s a rant for another day.)

The obvious solution would have been to let the USD spike higher to offset spiking oil prices. But, the Fed obviously didn’t see things that way. It took about a year to break out above the dashed red TL seen below, and another 4 months to backtest the rising purple channel which broke down in July 2020.The close-up:

The delay in DXY’s appreciation caused oil’s price gains to accelerate, eventually causing a breakout of the 20-yr old yellow channel.Again, this was a choice the Fed made, not a mistake. Think about that the next time you pay $70 to fill up your tank.

In any case, push has come to shove. The Fed can no longer define inflation away or insist that it’s transitory. It can no longer pour trillions into the market to artificially suppress interest rates, the cause of the bulk of the price inflation we’ve experienced.

The 10Y has broken out, completing an IH&S that targets an even bigger break out. It must be reined back in – at least by the time it reaches

Yes, there are supply constraints, but the Fed’s $9 trillion balance sheet has had a much bigger impact, spilling over into stocks, oil, lumber, real estate, manufactured goods, rent prices, wages, etc. in a way that the Fed can no longer deny.  The market has called bullshit, and the market is right.

Even in the face of this massive inflation, the Fed is still pouring billions into the markets in an effort to suppress interest rates.  It has very few other tools with which it can do so: crash oil prices, permit a scary equity correction, inflate the DXY, or wait.

There doesn’t seem to be much the Fed can do to crash oil prices (there’s a shortage of journalists volunteering to be hacked to pieces), or maybe they’re just hesitant given the strong correlation with stocks.

Of course, if our “permit a scary equity correction in order to drive money from stocks to bonds and drive down interest rates” scenario is anything more than a conspiracy theory waiting to come true, it makes a fair amount of sense.

By “wait,” I mean allow the YoY price delta on various CPI inputs to settle out.  This would be great if it worked – though Americans would be understandably upset if their wage gains hadn’t kept up over the same period.

After yesterday’s performance, I am more convinced than ever that Powell doesn’t plan to actually raise interest rates unless forced to do so. I believe the Fed is hoping the “waiting” strategy, combined with a higher DXY, will buy them the time they need for YoY deltas to fall back to normal.  This is a dangerous gamble since many inflation categories are notoriously sticky. But, we’ll see.

In the meantime, I have increasing confidence in DXY’s ability to extend its backtest to include the .786 at 100.04 if/when it tops the .618 at 97.73.

USDJPY:

A rising USDJPY also means a stronger dollar. And, the USDJPY is the principal player in the carry trade game.  If the Fed is finally okay with a rising DXY, the USDJPY should also continue to rise.But, there’s some heavy duty resistance just above current levels.

The rest of our charts:  Looks like ES/SPX little flag pattern should break down today, with the next lower targets to be tagged at ES 4153.62 and SPX 4136.15.