Dollar traders have kept a close eye on a potentially bullish "inverse head-and-shoulders" pattern building in the U.S. dollar index (DXY) chart. Meanwhile, the smell of a stronger greenback is weakening Bitcoin's (BTC) upside case, especially as the flagship cryptocurrency struggles to break out of its current $30,000-35,000 trading range.
Three troughs, one price ceiling
In detail, the inverse head-and-shoulders (IH&S) pattern forms after a downtrend. It contains three successive troughs, with the middle trough (head) being the deepest than the other two (shoulders). Ideally, the two shoulders are of equal height and width. All three troughs hang by a price ceiling known as a neckline that serves as resistance.
DXY, which measures the dollar's strength against a basket of top foreign currencies, currently checks all the boxes to prove that it has formed an IH&S pattern.
The index now stares at the prospect of undergoing a bullish breakout upon closing above its neckline resistance. In doing so, it would set up a technical profit target at a distance equal to the price gap between the neckline to the bottom of the head.
The bullish setup expects DXY to rise by almost 5% on a potential neckline breakout move.
Meanwhile, the index's 50-day simple moving average (50-day SMA; the blue wave) also anticipates to cross above its 200-day simple moving average (20-day SMA; the saffron wave) to confirm a Golden Cross. Traders consider golden crosses as bullish indicators.
Dollar fundamentals
A weaker dollar environment after March 2020 served as a tailwind for risk assets and global growth, propelled by the U.S. Federal Reserve's quantitative easing policies to cushion the economic aftermath of the coronavirus pandemic. DXY closed 2020 at a 6.83% loss.
But entering 2021, the dollar showed signs of trend reversals as the U.S. economy rebounded strongly amid a speedy coronavirus vaccination program. As markets reopened, demand for the dollar and dollar-based investments rose among global investors.
Brent Johnson, chief executive of Santiago Capital, called the dollar "Giffen Good," a type of asset whose demand increases with its prices. He noted that despite rising inflation caused by Fed's money printing, global investors had increased their dollar debts, adding:
"This continued debt issuance denominated in USD increases future demand for USD (the debt must be repaid in USD), and as noted above, this demand does not abate as price rises."
Kevin Kelly, the chief financial analyst at Delphi Digital, said that net speculative futures positioning on DXY is not as bearish it was at the beginning of 2021. He added that the setup is very similar to DXY's positioning in early 2018 that followed by a roughly 10% price rally in the next 18 months.
Inflation setup
A recent run-up in the DXY market came alongside three back-to-back monthly spikes in inflation. Per the latest Labor Department released this Tuesday, the U.S. consumer price index rose to 5.4% year-over-year, the highest 12-month rate since August 2008.
James Freeman, the assistant editor at the Wall Street Journal, blamed the Fed's money printing policies for the ongoing inflationary pressure, noting that the dollars in each wallet have been actively losing their value as a result. Nonetheless, the Fed has assured that inflation was a temporary problem, providing a bullish backstop to the DXY rally.
In his congressional testimony on Wednesday, Fed chairman Jerome Powell admitted that the economic conditions at present do not allow them to taper bank their quantitative easing programs, including a $120bn a month bond-buying program. However, Powell added that the Fed would alert markets in advance if they ever decided to scale back its purchasing.
Combined with lower rates, the Fed's expansionary policies have spurred cheaper lending, thus creating more demand for assets, including homes, tech stocks, gold, and even Bitcoin. But, at the same time, fears that a consistently rising inflation would prompt the central bank to cut rates have also pressured seemingly overvalued assets to lose a portion of their yearlong gains.
For example, Bitcoin, often propagated as a hedge against higher inflation, dropped by more than 50% from its record high of about $65,000. Its plunge largely appeared in the wake of regulatory crackdowns around the world, a Chinese mining exodus, among other factors. But the Federal Open Market Committee's decision mid-June to cut interest rates in 2023 may have also added to its downside momentum.
"If the US dollar reverses trend, it threatens to throw cold water on some of this year’s most popular trades," noted Kelly.
"Commodities, gold, emerging market equities, bitcoin are all vulnerable to a strengthening greenback, though the speed of its move also remains a critical factor."
Nevertheless, some analysts see a rising dollar as no threat to Bitcoin, believing that investors would keep allocating a portion of their portfolio to the emerging global asset.
ARK Invest Founder and CEO Cathie Wood, for example, told CNBC Bitcoin could end up on a more solid footing after overcoming worries related to the recent China crypto mining ban and its alarming carbon footprints, an issue raised by Tesla CEO Elon Musk in May.
An Intertrust survey of hedge fund chief financial officers worldwide also found that they would increase their crypto exposure significantly by 2026. 17% of respondents expected to allocate more than 10% in Bitcoin and similar digital assets.
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