The week ahead: could the US dollar recover?


US dollar gains slightly ahead of a very busy week
The greenback is not weak despite a major decline
EURUSD is reversing but buyers could be lurking around 1.23
The US dollar had an awful 2017 and instead of recovery it literally crashed in January 2018. This has left many analysts puzzled as bond yield spread seemed to favour the US currency. This week is full of the key macro data from the US, providing a chance for recovery. Where is the dollar and could it shine once again? We take a look at these questions in this analysis.  
Weak or strong? White House sending mixed signals.  

One of the undisputed reasons behind a recent plunge in the USD was a remark from Steven Mnuchin, the US Secretary of Treasury, who expressed his preference for a weaker dollar, deviating from the traditional "strong dollar" approach. Although his words were at odds with Trump who said that "ultimately he wanted to see a strong dollar" traders could be confused. Let us recall that Trump himself was sending very mixed messages about the greenback in a spring of 2017 so traders could be tempted to believe in a "moment of honesty" from Mnuchin" more than in Trump’s change of heart.  
The dollar is in a midst of a major decline when looked from a longer perspective. The US dollar index (USDIDX ) sees a resistance at 92 and a support at 84.50 points. 

However, could the White House determine the dollar rate? To some extent it could. The strongest influence possible seems to be via nominations at the Fed and a pick of dovish Powell at the expense of hawkish candidate may express a preference towards a weaker currency.  

Bond yield mystery - will it re-converge? 

One thing that’s been puzzling for analysts is a huge divergence between bond yields and the USD rate. Differences between bond yields often dictate a direction for fx rates for developed countries as they express what markets think about monetary policy. However, even as bond yields in US soared the dollar weakened, denying model implications. 
Bond market yields used to predict EURUSD movements quite well. However, these two markets have diverged substantially. 

One of the reasons might be that bond yields increase elsewhere as well. Yes the increase for EUR, AUD or CAD could be slower but often takes place from a lower level. Therefore, even as nominal difference in bond yields moves in favour of the US dollar, investors could be more impressed by a move on German bunds (because it’s taking place after a long stagnation). Although relationships like EURUSD vs 10-year bond yield used to work well, no one said it’d work forever - there’s no long term relationship between EURUSD and a given level of a difference in yields. 

US dollar is not cheap! 

Many commentators argue that we are in a period of "weak dollar". The US currency could be weakening but it’s not necessarily overvalued. To the contrary, US dollar inflation adjusted rate is still above a 20-year average. Although the difference is not as huge as it was a year ago it’s still narrowly higher than in case of the euro so from a valuation point of view one cannot argue that the dollar is too cheap to decline even more.  
Inflation adjusted USD rate remains above a 20-year average. From this perspective the US dollar is not cheap. 

Events, data to watch  

This leads us to events this week and the calendar is full of action: 

 2am GMT - President Trump delivers the "State of the Union" speech - a highly anticipated speech that may be short in details - "major" speeches in 2017 usually lead to a weaker dollar
 1:15pm GMT - the ADP report on employment
 7pm GMT - FOMC statement  - it’s the final meeting for Yellen but all we will get is a statement. We doubt a major change is possible at this point. Markets will be looking for the first post-meeting conference from Jerome Powell.  
 3pm GMT - ISM manufacturing - a major business survey remains in a "growth" territory but momentum is weaker than in the EMU
 1:30pm GMT - the NFP report - focus on wages; investors have been looking for a pick-up for a while... 
EURUSD rate offers some signs of a reversal but bulls could be lurking in a neighborhood of 1.23. 

Overall, some correction of the USD weakness could be seen as a well deserved. Indeed we can see an attempt of reversal on the EURUSD as an attack on highs on Friday failed and moving averages on H1 interval seem to be reversing downwards. However, traders should be sticking to technical analysis as buyers could be lurking around 1.23. When it comes to fundamentals, the only way to ignite a major rally in the USD would be to have much more hawkish Fed. We have not seen signs of this so any gains in the USD could be temporary.