Technical Analysis and The Economy

Chart Patterns Paint a Clearer Picture | IJS Speaks

June 08, 2023 IJS Speaks Episode 41
Technical Analysis and The Economy
Chart Patterns Paint a Clearer Picture | IJS Speaks
Show Notes

There is this Cup-and-Handle formation that is evolving on a 3-month chart of the Dollar Index, and I think the chart is presenting at the beginning of the handle portion of the chart pattern. I’ve been watching and trend-trading the dollar index against a basket of currencies, because I believe the forex markets have the most immediate link to the macroeconomy, and we are certainly living in interesting macroeconomic times. Cup-and-Handle chart patterns tend to signal a continuation of a trend in the direction of the breakout, so I zoomed out to a 1-year chart and saw what I initially thought was a ‘kinda weird’ Double Bottom formation, had the potential to form a ‘not-so weird’ (inverted) Head-and-Shoulders if the Cup-and-Handle played out. Technical Analysis talk aside, all three of the aforementioned chart patterns told me the same thing; the dollar was queuing up for a move higher.

The Cup-and-Handle overlays best with the current narrative in financial markets. The dollar first started trending higher as the debt ceiling negotiations began intensifying and the date estimated by the Treasury when America would run out of cash to pay its bills approached without an agreement. Before that point the dollar was trending sideways for about a month, which came after about a month of trending lower. The short-term peak in the dollar occurred around the time an agreement was reached between Democrats and Republicans about the US debt. This is when the pattern caught my attention, as the price on the index started rolling over into the beginning of the handle. 

The next macro event on the economic calendar is the June Fed meeting (13th-14th) which will conclude with the Fed deciding to either raise interest rates or hold them at current levels until their next meeting in July. The market consensus appears to be that the Fed will hold rates steady at its next meeting and maybe even at its subsequent one, which is in-line with what Fed officials have been saying. Then the two go their separate ways. The Fed has and continues to say that rates are meant to stay higher for longer, and market participants are suggesting that rate cuts can begin as early as the fourth quarter of this year. Financial markets are also implying that because the Fed should be cutting rates by years end, the dollar has peaked and should be weakening as higher foreign rates begin to look more attractive.

The inevitable divergence of views between the Fed and market participants completes the handle in the formation. The capitulation of market participants will later drive the breakout of the pattern, which on the longer timeframe would lineup with the breakout of the (inverted) Head-and-Shoulders as well. 

Let me explain. Markets agree with the Fed that rates remain unchanged at the June meeting, which to the Fed means rates remain unchanged at the June meeting and nothing more. To market participants, however, it means rates have peaked and after a short pause they are coming down, so the dollar sells off. When we get to the next meeting if there is still no rate change because monetary policy operates with long and variable lags, markets will infer that we’re even closer to a rate cut especially if the economic data worsen, so the dollar may tend to trade sideways. Finally capitulation can/may occur when later in the year the Fed surprises markets with a rate increase despite further deterioration in the economic environment simply because inflation will have remained sticky above their target of 2%. Short dollar positions would have to cover losses, and some will even reverse course, all of which will push the dollar higher. 

Then there’s the issue of the Fed further tightening monetary policy while economic activity slows, while labor hoarding and consumer credit keeps a floor under inflation. Economic weakness at home and abroad could move the needle on market sentiment towards one that embraces...