UDN: The Reasons For Selling The Rally In The U.S. Dollar Index (NYSEARCA:UDN)

The US Dollar Index (DXY) measures the world’s reserve currency against a basket of other reserve currencies, including the euro, British pound, Japanese yen, Canadian dollar, Swedish krona, and Swiss franc. The index is most sensitive to the euro, as it has a 57.6% weighting to the European currency, the world’s second-leading reserve foreign exchange instrument.

The dollar index broke out to the upside in May 2022 when it surpassed the March 2020 103.96 high and rallied to 114.745, the highest level in two decades since 2002.

The index ran out of upside steam at the September 2023 high and plunged below 101 before recovering to over the 104 level, which is now the pivot point. We could see more selling in the dollar index in the coming months, and the Invesco DB US Dollar Index Bearish Fund (NYSEARCA:UDN) is an unleveraged product that moves higher when the dollar index declines.

A significant correction from the September 2022 high

After reaching 114.745 in late September, the dollar index ran out of upside steam.

The long-term chart highlights the dollar index dropped to 100.68 on February 2, 2023, a 12.3% decline from the late September peak. The index fell as the trajectory of interest rate hikes slowed from 75 to 50 to 25 basis points over the past months. However, the Fed remains committed to a hawkish monetary policy path. At the most recent early February FOMC meeting, the committee said further rate hikes remain “appropriate.” The dollar index found a bottom above the 100 level in early February.

The dollar index has bounced from the recent low

After reaching the February 2 low, the dollar index has made higher lows and higher highs.

The chart illustrates the dollar index’s bullish pattern over the past weeks that took it above the 103.96 technical resistance level and above 104.50 on February 22. 103.96 was the long-term resistance level that became support during the index’s ascent to 114.745 and resistance again when it fell below the 101 level. In late February 2023, 104 is now a significant pivot point for the metric that measures the U.S. dollar’s value against the other world reserve currencies.

The dollar index is losing relevance

The British pound was the world’s reserve currency before the U.S. dollar took over because of the rise of the U.S. economy and political stability as the “leader of the free world.”

In February 2022, the handshake between Chinese President Xi and Russian President Putin was a watershed event, creating a bifurcation of the world’s nuclear powers. Russia invaded Ukraine, and the ongoing war has caused U.S.-Russian relations to deteriorate to the worst level since the early 1960s Cuban Missile Crisis. China’s increasingly aggressive stance against the U.S. and its desired reunification with Taiwan have damaged U.S.-Chinese relations.

For decades, the U.S. dollar has been the world’s reserve currency. Sanctions on Russia and the bifurcation of the nuclear powers have caused the Chinese-Russian alliance with nuclear partners in North Korea, Iran, and other supporting countries to begin developing systems to pay for cross-border transactions with non-dollar assets to circumvent the potential for sanctions.

In 2022, Russia declared that 5,000 rubles were exchangeable for one gram of gold to bolster its currency and avoid sanctions from the U.S. and Europe. China has been negotiating with Saudi Arabia and other commodity-producing countries for trade using non-dollar assets. The bottom line is that geopolitical tensions are causing the dollar’s role in the global financial system to decline.

Meanwhile, the U.S. Fed created and was behind the inflationary curve and could now be behind the recessionary pressures growing as the central bank pushed rates higher to slow the economy. A recession would likely cause the Fed to slow, stop, or even reverse its hawkish monetary policy path, causing the dollar to decline.

The coming debt crisis is bearish for the dollar

The U.S. national debt has increased to over $31.5 trillion on the domestic front. The Fed Funds Rate at a midpoint of 4.625% in late February 2023 means servicing the debt costs an additional nearly $1.5 trillion annually, pushing the debt higher even if the U.S. government curtails borrowing to fund military, social, and other initiatives.

One of the leading issues facing Congress is increasing the debt ceiling. The slim Republican majority will likely seek spending concessions from the Biden administration, which has said it will not negotiate. The debate sets the stage for a potential default, which would decimate the U.S.’s credit rating, weigh on markets, and could cause the dollar’s value to decline. A debt crisis with no resolution could cause a significant drop in the dollar’s value against other world foreign exchange instruments. Therefore, the dollar faces bearish factors on the international and domestic fronts.

UDN is the bearish dollar index ETF product

The most direct routes for a risk position in the dollar index are via the futures and futures options on the Intercontinental Exchange or via the over-the-counter foreign exchange market. The Invesco DB US Dollar Index Bearish Fund provides an alternative for market participants looking to short the U.S. dollar index without venturing into the futures or OTC markets.

At $18.38 per share on February 22, UDN had nearly $107 million in assets under management. UDN trades an average of 249,315 shares daily and charges a 0.77% management fee.

The dollar index fell 12.3% from the late September 2022 high to the early February low.

The chart shows that UDN rose from $16.75 to $18.98 per share or 13.3% over the same period, as the unleveraged ETF did an excellent job tracking the dollar index’s decline over the past months.

An impending debt crisis and a bifurcated geopolitical landscape are challenges to the dollar’s role in the global financial system. UDN is a product that will benefit from a continued decline in the dollar index.