Is The Dollar Overvalued?

Lior Alkalay - Contributor - Forex

The US economy just seems to get better and better; better than robust retail sales, knockout earnings in payrolls and confident consumers raring and ready to spend more and more. Yet, after a rally that stretched all the way from early May, the last few days have been rather mixed for the Dollar, turning its monthly return against peer currencies into a virtual flat line. What might be the reason for that and should it affect your FX strategy? The answer to those questions is our focus for today.

The Growth Gap

If the outlook for the US economy and the US Dollar are so positive, what then could make investors question their Dollar bullish bets?

The answer is the growth gap. Back in May, stimulus from the ECB was but a mere speculation and more easing from the BOJ seemed relatively remote. And what was on the plate then? More of a slowdown in Europe, more sluggishness in Japan and a "soft landing" in China. All the while, expectations were that US growth would accelerate, thus narrowing the growth gap with China and broadening the gap with Japan and the Eurozone. And so it did. Yet now, in spite of all the good news out of the US, the massive stimulus in Europe and Japan may suggest a different scenario; a scenario where the growth gap between the US and its peers reaches its critical mass over the short run. If that happens, the Japanese and the Eurozone economies will have nowhere to go but up. It would seem then, that investors, rather than being less optimistic on the US, are instead becoming less pessimistic on America's peers.

Uncertainty Over Fed Policy

While this gap propels investors to curb their Dollar bets, it also, more importantly, affects another group of decision makers and that is the Federal Reserve Bank policy members. The FOMC, which is set to meet next week, has several concerns, with the growth gap one of the major worries. Of course, the growth gap is not, in and of itself, a reason to worry. However, the US might find that its hawkish stance, in utter contrast to the rest of the world, poses a risk to long term growth. Although US economic activity does justify a more hawkish trajectory, the stark contrast of the US versus the rest of the world may lead the US Fed to tame some of its language in an effort to slightly ease the rate expectations gap between the Fed and its peers. Moreover, and despite evidence, plunging oil prices may propel consumers to spend more, a scenario foreseen by the Fed's Vice Chair Stanley Fisher. Thus the Fed might be tempted to sneak in a warning on inflation sliding lower. And that is the uncertainty that investors fear will hit the Dollar in the short run as the Fed might try to attempt, even if only temporarily, to throw sand in investors' eyes.

The Big Picture

How then can we sum up what all those various factors might mean as they relate to the potential for the growth gap to narrow and uncertainty from the Fed? It is that investors might find it a little too tempting not to diversify to European or Japanese investments denominated in Euros and Yens that now, in Dollar terms, are at a great discount. But even after all the evidence there is one point – one tipping point – which is missing and that's the technical aspect. In other words, if the technical picture as reflected by the price action of Dollar pairs does not reflect an imminent correction, then perhaps investors think the balance between the Dollar and its peers has not reached the tipping point where it's overdone.

Wisdom Of The Technicals

So what do the technical say? If we take a look at the Dollar Index chart below we can learn two things. The first is that the RSI (Relative Strength Index), which is above 70, suggests that the Dollar is overbought on a multi-month level. The second pattern that emerges is one that is so simple yet so revealing. As seen in the chart, if the Dollar Index fails to close the month higher than where it is today, it will establish the 88.5 level as a "triple top" or three failed attempts to break higher, and that is one of the most basic signs of a correction. Does this mean the Dollar rally is over? Most certainly not, in fact, we might be in the midst of a multi-year Dollar rally. Yet this does certainly mean that after riding the Dollar higher over the past six months, it's perhaps time to diversify into other currencies, at least until the Dollar is attractive again.

Look for my post next week.

Lior Alkalay Contributor - Forex

Disclosure: This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from for their opinion.

5 thoughts on “Is The Dollar Overvalued?

  1. I think, it is batter to say that "Only Dollar is Valued"

    Considering Exchange Rates, With some minor exceptions, Majority Currencies of world is undervalued compare to Dollar, and considering ever rising and sky rocketing U.S. Debt I just cant understand this paradox, and may be possible that it can be treated as a warning signal of collapsing entire world economy.

  2. 2004 and 2006 saw the dollar index float about 90 for many months. Yes, you're right to question the staying power of the dollar above such levels. I too have been expecting a plunge. The crude oil factor though is causing some shifting in this position however. If crude oil stays low, many tremulous country currencies will begin to suffer even more. When this happens the dollar will yet again climb and stay strong. Venezuela, Nigeria, Libya, Russia, Oman, and many others all are teetering on the brink of some sort of tumultuous event if crude stays below 60 for long.

    Yes, time to diversify out of the dollar. But into other currencies? I'd rather buy grains which have been bucking the dollars rise. Or cotton, cocoa and copper.

    1. Hi Anonymole,

      Thank you for your comment. I agree with you that the agricultural space contains some very good diversification options such as Cocoa. However the quick appreciation of the Dollar at the moment, reflects a very positive outlook for the US and a very dark one for Europe, Japan and even the UK. In that context I believe a positive surprise from those economies is not priced in the FX market and therefore creates a good opportunity to diversify into holdings denominated in other currencies. In other words I was focusing on the diversification options across the FX space rather than across assets.

      Thank you.

  3. I have heard this comment before. "low energy prices will cause consumers to spend more causing inflation"
    WHY?? The consumer only has a finite amount of money to spend, If the public doesn't spend it on energy, he spends it elsewhere, but it is still the same amount of money. How is this inflationary?

    1. Hi Bob,

      First you are right to question the idea that lower Oil will cause consumers to spend more as they may also use lower prices to save more. However when consumers are confident they tend to exploit lower prices to spend more. This is also supported by the latest Retail Sales figure and has been suggested by the Fed Vice Chair , Stanley Fisher. Moreover lower energy prices may improve corporate profits and combined with a tightening job market could lead to higher wages which as you probably realize leads the consumer to higher spending. That is basically the case for consumers spending more under lower oil prices. However if confidence falls again, the consumer could quickly shift to saving from spending.

      Thank you.

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