Beware of dollar index volatility before consolidation

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The U.S. dollar is on a tear amid expectations that the Federal Reserve will hike interest rates later this year against a backdrop of easing in many of the world's economies, but charts suggest the potential for volatility before the greenback consolidates those gains.

The U.S. dollar Index, which measures dollar's value against a basket of foreign currencies – the euro, Japanese yen, pound sterling, Canadian dollar, Swedish krona and the Swiss franc – has risen 25 percent from $0.80 in July 2014 to above $1.00 this week. Changes in the dollar index have a large impact on U.S. trading partners, such as China, Mexico, South Korea and Brazil, but these currencies are not included in the dollar index calculation.

A 25 percent rise is unusually large, so some analysts think the dollar index will stabilize around $1.00. Chart analysis suggests there are four key questions. This analysis is best seen on a monthly chart where each candle represents one month of dollar index activity.

Question 1: Is the dollar index value at $1.00 unusually high?

From 1997 to 2000 the dollar index traded in a consolidation band between $0.99 and $1.02. The current value near $1.00 is inside the historical trading band. The dollar index may develop a consolidation pattern between $0.99 and $1.00.

Question 2: Can the dollar index go higher and what are the target levels?

In 2001 and in January 2002 the dollar index peaked at $1.205. It is possible that the dollar index will breakout above $1.02 and move higher.

Question 3: How sustainable was the breakout above $1.02?

The breakout above $1.02 in January 2000 developed into a well-defined and sustainable uptrend. The uptrend was contained in a unsloping trading channel around $0.10 wide. The key feature is the stability of the uptrend following the breakout above consolidation between $0.99 and $1.02.

Question 4: Are there similarities between 1997 and today?

There is a very important difference. In 1995 to 1997 the rise from $0.80 to $1.00 was a more stable trend than the rise from July 2014 to today. Fast rises are often followed by substantial retreats. The potential for retreat is the key risk in the current dollar Index environment so investors will carefully watch for consolidation to develop between $0.99 and $1.02. A retreat below $0.99 has the first support target near $0.89. A breakout above $1.02 has the first resistance level near $1.09.

The very fast rise from $0.80 to $1.00 suggests a greater potential for market volatility until the consolidation pattern is confirmed.