Trading the Dollar as Trade War Looms

As the trade war between the world’s biggest and second biggest economies intensifies, leaders of both the US and China seem determined to continue to slap tariffs on each other, most likely fearing the loss of “face” among people in their respective home countries.

This past Tuesday, a new round of tariffs was announced by US President Donald Trump, targeting an additional US$200 billions of Chinese goods, with another US$26 billions already announced to be on the horizon if the Chinese responds.

The question you may be asking now is why this matter to us as forex traders.

The truth here is that the forex market is probably the most sensitive market to any kind of developments involving US trade relations. Trade between the US and other countries is always paid for in US dollars, and even in cases where trade doesn’t involve the US, it is often paid for in US dollars.

In times of financial or political turmoil, capital tends to seek the perceived safety that the US dollar offers. This is what has been happening since the beginning of 2018, as demonstrated by the US dollar index (DXY), which is now up 7% since its low in February this year.

As China and other countries are getting increasingly frustrated with US trade policies, we are starting to see signs of a new trend where countries around the world, in particular China, Russia, Iran, and Turkey, are looking for alternatives to using the dollar when they trade between each other. If this succeeds, and even just a small part of international trade moves to currencies other than the US dollar, the dollar is in big trouble.

Taking a technical perspective also suggests that the US dollar rally may be coming to an end. Just from looking at the dollar index chart, most traders who understand basic technical analysis would agree that it looks “top heavy.” The DXY chart now essentially looks like a market that wants to fall, after the strength of the previous uptrend gradually has faded away.

As seen in the chart above, we had a divergence between price and the RSI indicator between June and July – a clear sign that the momentum of the uptrend was fading. Now, we are seeing another technical sign that a reversal to a downtrend may be imminent in the form of what many would agree looks like a head-and-shoulder pattern. In addition, price has been trading below the 20-day moving average consistently for some time, further strengthening our bearish bias for the US dollar.

As forex traders, weakness in the US dollar impacts most currency pairs we trade in, although to a varying extent depending on the performance of the other currency in the pair. This is why the two best ways to measure the performance of the US dollar by itself is either in the form of the DXY chart above, which is an average of the US dollar’s performance against other major currencies, or against gold, which has been proven to be an effective insurance against currency risk for hundreds of years.

In the current market environment, one specific thing you might want to consider is to avoid taking short-term trades that goes against the longer-term trends in the market. This means that if the US dollar in fact reverses and enters into a downtrend, long positions on pairs like the USD/AUD or the USD/NZD may be vulnerable. Instead, continue to follow your trading strategy but filter out signals for trades that goes against the broader market.

As we have mentioned before, important news always trumps technical analysis. No matter how solid your technical indicators or strategy may be, it will fail when news about the trade war or the US dollar’s status as a strong global reserve currency gets out. And with both fundamental and technical factors stacking up against the dollar, it may be time to take a more cautious approach to this particular currency.