Dollar Index retreats from 20-year highs, but will DXY peak trigger Bitcoin's recovery?

The U.S. dollar index (DXY) has pulled back from a bull run across the board in the past two weeks, losing as much as 3.20% after hitting a 20-year high of 105.

Risk of overvaluation looms over dollar market

The dollar's pullback over the past two weeks comes ahead of a 12-month run of sustained buying.

All told, the dollar's weighting against a basket of major foreign currencies has risen about 14.3 percent in a year, largely as markets seek safety against concerns of a hawkish Federal Reserve and the recent military clashes between Ukraine and Russia.

DXY Weekly Chart Source: TradingView

Bank of America's recent survey of 288 asset allocators showed that since 9/11, global fund managers' cash balances have grown by an average of 6.1%. The report also noted that 66% of asset managers believe global profits will decline in 2022, prompting them to hold "overweight" cash positions.

“Markets have accumulated a lot of dollars in recent months,” Deutsche Bank strategist George Saravelos told the Financial Times, adding that this “results in a grossly overvalued dollar.”

As such, the dollar's recent pullback could be a temporary correction to neutralize its "overbought" condition, as indicated by the greenback's weekly relative strength index (RSI) reading (chart below).

From a further technical standpoint, the U.S. dollar index could fall further towards an uptrend line that has acted as a support level that has limited its downside since January 2021, as shown in the chart below.

DXY Weekly Chart Source: TradingView

If there is more selling, the index may retrace from the current resistance zone, with the next downside target at the 0.786 Fibonacci retracement around 100.

A stronger outlook for the euro

The U.S. dollar index also retreated earlier in the week as European Central Bank (ECB) President Christine Lagarde enacted a new, more hawkish policy on May 23.

Lagarde pledged to raise rates in September 2022, ditching a decade of dovish ECB monetary policy that has effectively led to negative interest rates.

As a result, euro zone interest rates will bounce back to zero, a prospect that has strengthened the euro against the dollar.

EUR/USD Weekly Chart Source: TradingView

But recent IFO surveys show confidence in business growth remains strong in the euro zone despite the ongoing Ukraine-Russia crisis and disruptions in energy supplies. That means the euro will get a bigger upside boost, which in turn could weigh on the dollar lower.

Ifo survey shows strong German business confidence Source: Bloomberg

"It's too early to say with confidence that the dollar has entered a weakening trend," said John Authers, senior editor at Bloomberg Opinion, adding:

"But its decline suggests that the 'stagflation and higher interest rates' narrative is being reconsidered."

Emerging Market Currencies vs Bitcoin

A weaker U.S. dollar index simply represents a decrease in its weight relative to foreign currencies. But an in-depth study of the dollar shows that its purchasing power is weakening in a high-inflation environment. As of April 2022, the Consumer Price Index (CPI) exceeds 8%.

As a result, while the dollar was stronger than it was a year ago, it failed to trap emerging market currencies, breaking their widely-watched negative correlation.

Notably, developing country currencies such as the Brazilian real (BRL) and Chilean peso (CLP) have consistently outperformed the U.S. dollar since January 2022.

BRL/USD and CLP/USD daily chart Source: TradingView

Emerging market currencies tend to underperform when the greenback rises, largely because investors view the greenback as their ultimate safe-haven during times of global market uncertainty. But investors are rethinking their strategies as the Ukraine and Russia crises send commodity prices higher.

Meanwhile, countries that raise interest rates are also creating better investment conditions for their national currencies, said Stephen Gallo, European head of FX strategy at BMO Capital Markets.

Excerpts from his remarks to The Wall Street Journal follow:

"Emerging market central banks are being forced to tighten policy to keep pace with the Fed. Either do that or impose capital controls."

The ongoing power struggle between the U.S. dollar and emerging market currencies keeps Bitcoin out of consideration. It has lost more than 50% of its value since November 2021 and still has a lot to do with risk assets.

Daily chart for BTC/USD showing its correlation with DXY and EUR/USD Source: TradingView

However, Bitcoin’s long-running negative correlation with the U.S. dollar index has turned positive this week. This suggests that further losses in the U.S. dollar market may not trigger a recovery in Bitcoin prices anytime soon.

As Bitcoin struggles to climb back to the $30,000 mark, calls for a macro bottom of $20,000 or even lower are growing, Cointelegraph reported.

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