US Dollar Index: DXY is on the Verge of a Major Meltdown

The US dollar index (DXY) pulled back on the first trading day of the year amid thin volumes. It plunged to a low of $103.44, which was the lowest level since June 16 of 2022. It has fallen by over 10% from the highest point in 2022 as investors assess the next moves by the Federal Reserve.

US bond yields retreat

The DXY index retreat has coincided with the decline of American bond yields. The 10-year government bond yield has pulled back from its 2022 high of 4.33% to 3.87%. In the same period, yields of the 30-year government bonds fell from 4.4% to 3.9%. These yields remain close to their highest level in more than a decade.

The performance of the bond market is a reflection of what the market expects the Fed to do. In its December meeting, the Fed decided to hike interest rate by 0.50%. It then hinted that it will continue increasing rates in 2023 even as inflation declined for the second straight month. According to the Bureau of Labor Statistics, the headline consumer inflation data declined to 7.3% in November. 

Therefore, the US dollar index has declined because investors expect that the Fed will be less hawkish than it was in 2022. It hiked interest rates by 450 basis points and started its quantitative tightening policy that is reducing its balance sheet.

Inflation expectations slip

The DXY index has retreated as hopes that America’s inflation will continue falling increased. The closely-watched 10-year breakeven rate has dropped from a high of 2.98% in April 2022 to the current 2.30%. This is an important figure that measures the expected inflation according to Treasury Constant Maturity Securities. 

Breakeven point
10-year breakeven point

Inflation will likely continue falling because of a sharp reversal in factors that caused it in 2022. For example, supply chain disruptions have eased, with shipping costs dipping to the lowest level in years. In the same period, high inventories, especially in semiconductors has surged as demand for gadgets eased.

Inventories have also jumped in other industries. Higher inventories leads to lower prices. Further, crude oil prices are well lower than where they were in the first quarter of 2022. And the natural gas price has declined as hopes of a warm January rise.

US dollar index forecast

The daily chart shows that the DXY index has been in a strong bearish trend in the past few weeks. As it dropped, it managed to move below the 38.2% Fibonacci Retracement point. At the same time, the 50-day and 100-day moving averages have made a bearish crossover while oscillators have kept falling. 

Therefore, the outlook of the US dollar index is bearish, with the next key support level to watch being at $100. A move above the important resistance point at $105 will invalidate the bearish view.

US dollar index
US dollar index chart