This article was written exclusively for Investing.com
The dollar index has been rising steadily now for several weeks. With the Fed’s latest minutes indicating a tapering of asset purchases is near, the greenback may only continue to rally. The index is now in the process of breaking above a critical level of resistance, and once that break out is complete should have plenty of room to rise. This is likely to be costly to commodities and markets aboard, pressuring them lower.
Additionally, the USD has benefited from interest rate spreads widening between US and foreign bond yields. Also, with rates higher in the US than in other parts of the world, the demand for dollars will remain strong as foreign buyers of US bonds will sell their local currency to buy US debt in dollars.
A Massive Bullish Breakout Looms
All of this is helping to fuel the dollar’s rally and creating a bullish technical formation known as a double bottom. This pattern was created when the dollar index bottomed in January 2021 and again in May 2021. The dollar index needs to rise above resistance around 93.50 to confirm the double bottom and break out from that pattern. It is likely to fuel a rally to around 94.60 on the index, but a breakout could run to as high as 98 over time.
The momentum indicator, as noted by the relative strength index, is very bullish. It is in a clear uptrend and showing that positive momentum is moving into the index. The relative strength index is also in a long-term uptrend, which indicates the dollar’s rally is not likely to be a short-term event.
Negative Ramifications
If the dollar breaks out as the chart suggests, it is likely to push commodity prices like oil and copper even lower. Both oil and copper have fallen sharply over the past few weeks, with both slumping by more than 15%. A strong dollar is likely to continue to weigh on commodities like these, should it continue to strengthen.
It is also likely to hurt emerging markets and export economies as a stronger dollar will bring inflationary forces, making goods and services more expensive and slowing economic growth in these markets. Perhaps one reason why there has been a sharp divergence in recent weeks in international and US markets. For example, the iShares MSCI ACWI ex-US ETF (NASDAQ:ACWX) has fallen by more than 6% since June started. Meanwhile, iShares MSCI Taiwan ETF (NYSE:EWT) and iShares MSCI South Korea ETF (NYSE:EWY) ETFs are down by roughly 7.5% and 13%, respectively.
Just What The Fed Needs
There is also one other thing to consider. That is how a strong dollar could be the Fed’s best friend right now, especially as so many investors worry about out-of-control inflation. Clearly, should the Fed continue to communicate to the market that tapering is coming, it would be, in a way, jawboning the dollar higher. As a result, it is helping to do what is needed to keep inflation in check. A strong dollar will lower commodity prices and import deflationary forces to the US economy, as goods imported to the US from abroad will become cheaper.
The ramification of the dollar index breaking out here and pushing higher can be broader reaching and is likely to inflict a lot of pain in different sectors of the financial markets. Given the S&P 500’s significant advance and all of the damage the dollar is likely to cause, even the S&P 500 may not be immune to its effects over the longer-run.