US dollar reversal may spark meaningful unwind in Chinese yuan, Japanese yen

• USD index reverses hard, generating bearish technical signal
• USD/CNH holding just above key technical support level
• Chinese yuan has been influential on other Asian FXC names recently, including Japanese yen

DXY reverses brings CNH into focus

With the US dollar staging a big bearish reversal to kick off the trading week, there’s a risk we may see follow through selling before the release of the key core PCE deflator on Friday, the Federal Reserve’s preferred inflation measure. If that does eventuate, keep an eye on USD/CNH which may be influential on the broader Asia FX space, including the Japanese yen.

DXY reverses hard following bullish break

It was obvious to anyone reading my analysis on Monday that I was not convinced the bullish break the US dollar index (DXY) saw on Friday would stick when you look the fundamentals underpinning it.

It was sparked by unusual strength in the S&P Global US composite PMI, conflicting with the bearish signal from most other US economic data recently. It also occurred before Friday’s important US core PCE deflator, an indicator likely to show a big slowdown in inflationary pressures relative to what was seen earlier in the year, adding to the risk of Fed rate cut bets swelling. Sentiment towards the euro, the largest component in the DXY, was also overly pessimistic thanks to uncertainty generate by looming French elections.

Put together, the message from the technicals was not confirmed by fundamentals, and eventually fundamentals won out.

You can see the bearish engulfing candle on the DXY daily chart, generating a reversal signal. While the last delivered a false signal, those before it preceded follow through selling in the dollar, so its recent track record has been decent. With RSI breaking its uptrend, it adds to the message that bullish momentum is waning.

Given the reversal signal, a potential retest of the 50-day moving average may be on the cards, a level the price probed unsuccessfully to the downside for large periods last week. Below, the 200-day moving average and 104.00 are the downside levels to watch. On the topside, Friday’s high of 105.915 is now important. 

USD/CNH in focus for Asia FX traders

If we do see further weakness in the US dollar, it may pay to keep an eye on USD/CNH, the offshore traded Chinese yuan, given it not only led the latest run higher in USD/JPY buy has also had a strong correlation with USD/JPY over the past month. While it’s not been strong over the same period, USD/CNH has also had a strong inverse relationship with AUD/USD and NZD/USD over large periods this year.

It doesn’t get the attention it deserves as a key driver of Asia FX market movements.

Looking at USD/CNH on the daily timeframe, it sits at an interesting juncture on the charts, testing uptrend support after the completion of an evening star pattern in the prior three sessions, an obvious topping pattern. With horizontal support at 7.2800 just below, you get the sense that if USD/CNH can reverse back through these levels and stay there, it may flow through to similar moves in JPY, AUD and NZD against the USD.

USD/JPY rally stalls below 160

Given the correlation with USD/JPY, should we see USD/CNH break lower, the unwind in the former could be significant given how far the pair has run this year.

It’s notable the latest push higher in USD/JPY stalled ahead of 160, with traders understandably nervous to push pair too close to where Japan’s Ministry of Finance ordered the Bank of Japan to intervene back in late April. While the hammer candle on Monday suggests there are willing buyers around on pullbacks, with the bullish break not underpinned by a similar bullish move in rates markets, conditions are there for a meaningful pullback should we see further dollar weakness.

158.25 was where the latest bullish break started making that the initial downside level to watch. Above, the multi-decade peak of 160.17 is very important from a technical perspective.

-- Written by David Scutt

Follow David on Twitter @scutty