Where's the dollar strength going to come from?

Equities have had a bounce!

There's maybe some technical reasoning here.

The 100 daily exponential moving average has shown some support.

I'd argue though that it's more to do with weakness outside of the US and a forced rotation into US equities after the threat of more lockdowns and the financials facing weakness yesterday saw broad weakness on European bourses.

But I want to focus on USD here since, in my view, starting from what the dollar is doing is the most important aspect of taking a top down approach to markets.

Above is the dollar index - a mirror image of EURUSD (which is why I tend to say just look at EURUSD rather than the dollar index since it's actually tradable), but, since I prefer to look at a chart that goes up, we'll look at it this time.

We've got an important juncture just above with 93.90/94.00 acting as resistance here.

My thoughts for today are that Evans and Powell may lead to a love back into the range as they try to reaffirm some dovishness, although their speaking slots aren't exactly meant to be major market moving events.

This from Andreas at Nordea is quite important though, I feel...

See, I posted a chart last week from Unicredit which showed that the Fed were sucking up Treasury issuance from the US government.

Here it is again.

But, their balance sheet hasn't been largely increased by this.

Rather, it has stayed pretty neutral over the last quarter or so.

This is what Andreas is getting at here.

By not printing above what the US Treasury issue, there is largely no real weakening of USD that can occur, since supply is not outstripping demand.

This is probably a large factor as to why we've seen a pretty rangebound dollar through August...

The corresponding belief of more QE perhaps hasn't fed through in the end, and is largely one of the reasons why I think there are tightening USD conditions coming up.

And that's shown by the chart below of the FRA/OIS spread and the dollar index.

What are we looking at here?

FRA = Forward rate agreement

OIS = Overnight index swap

You're looking here at the price at which banks will loan to each other at.

Since banks rely heavily on USD to allow for the free flow of credit, it's likely that a rising FRA/OIS will mean a stronger dollar.

As we can see, the spread since early in 2020 has flattened.

But it's gradually rising at the moment, and there's no coincidence that the dollar is going with it.

What can it indicate?

Well, a rising spread is likely to indicate deteriorating credit conditions and greater banking risk - not of banking collapse, of course.

But the key takeaway for us is that if this continues to tick up, many are likely to seek USD safety.

The last time it ticked up nice and high in March, it was a 7 std deviation move...

Something that happens once every 3 billion years (yes the normal distribution is broken in financial markets a lot).

Recall what happened back then...

The Fed opened USD swap lines with other central banks to ensure that dollars were freer to flow - to ensure that everything could be paid for.

The Fed have kept their dollar swap lines open with some central banks through to March 2021.

My thoughts are that these will open up again, but at which point it will likely be too late and the dollar will already have risen (great for us).

But we can also look at how these swap lines have firstly contributed to the flattening of the Fed's balance sheet, spoken about above, and secondly, how the lack of use now will likely contribute to a stronger dollar.

Here's the total amount outstanding.

As risk has been on the menu over summer (largely probably due to the fiscal and monetary expansion in response to the pandemic), we haven't really seen a requirement to be bid USD.

That's changing in my view.

With government reactions to the pandemic now returning across Europe, the natural capital flow will be back to the US, both to USD and those 'sovereign bond' stocks at the top end of the Nasdaq.

Couple that with the election risk and seasonal volatility, and I reckon there's a great shout for the dollar showing more face melting strength through the next month or two as I have maintained for a while.

As the FRA/OIS shows, the dollar reigns king as a risk off asset, and rightly so.