As the G20 concludes and the US equity markets decline, the US dollar is playing pivotal role in both the foreign currency markets and geo-political posturing. Last fall, during the height of the economic crisis the US dollar index broke a 6 year downtrend which began in 2002. As the dollar peaked in March 2009, the US equity markets began to find firmer footing and the year long relationship between the dollar and equities blossomed.

US Dollar Index (Cash) – Monthly Chart

Over the last 6 months the Us dollar index has declined in what may turn out to be a correction. Furthermore, over the last 6 months both the implied volatility and historic volatility have been cut in half from above 20% to below 10%.

Implied Volatility and Historic Volatility on US Dollar Index Futures Options

We also note that since the beginning of September the implied volatility index has climbed substantially above the historic volatility. The implication is option traders have been expecting a big move in the dollar index.

While implied volatility tells us what the market is expecting it does not tell us the direction of the expected volatility. In the US dollar index, the implied volatility on both the puts and the calls have been rising in tandem, which means they offer little information for directional analysis.

Combining the technical and volatility analysis we deduce the likelihood of a dollar reversal has increased significantly. Adding the weakness in the US equity markets fortifies our conclusion. Just as the weak dollar fueled the rise in the equity markets it is possible that the strong dollar fuels a decline.

The two markets can form a vicious circle that mirrors the action we have seen over the last 6 months. The stronger the dollar gets the weaker the equity markets become, this weakness in turn causes a flight to safety and the dollar becomes stronger.

But what is the fundamental fuel for a rising dollar? Glad you asked.