Records were broken and important technical levels fell with the dollar’s incredible rally last week. However, there was no specific top-tier indicator to trigger such a monumental move. So, is this just a remarkable false breakout or the inevitable fundamental shift behind a long-term trend change? To answer that question, we need to consider the fundamental buildup to the biggest one-day greenback advance in over five years and the longest overall sustained rally since the 2005 bearish reversal. On the outlook for growth, the second quarter GDP reading from the previous week seems to have placated the market; but that shouldn’t blind us to the first drop in growth since 2001 reported in the revision to the 4Q 2007 figure. Nor should it overshadow the significant burden on the outlook for expansion over the second half.

US Dollar Breaks Records/Resistance, Will The Rally Continue?

Fundamental Outlook for US Dollar: Bullish

- A Shift In Growth And Interest Rate Expectations Finally Lead The Dollar To A Major Technical Breakout
- FOMC Rate Decision Passes Without Incidence, Yet Speculators Are Still Hawkish On Rate Outlook
- Dollar Breakout Presents Significant Trading Opportunities In GBPUSD And Other All Majors

Records were broken and important technical levels fell with the dollar’s incredible rally last week. However, there was no specific top-tier indicator to trigger such a monumental move. So, is this just a remarkable false breakout or the inevitable fundamental shift behind a long-term trend change? To answer that question, we need to consider the fundamental buildup to the biggest one-day greenback advance in over five years and the longest overall sustained rally since the 2005 bearish reversal. On the outlook for growth, the second quarter GDP reading from the previous week seems to have placated the market; but that shouldn’t blind us to the first drop in growth since 2001 reported in the revision to the 4Q 2007 figure. Nor should it overshadow the significant burden on the outlook for expansion over the second half.

The Federal Reserve continues to warn the market about the downside risks to growth – and for good reason. The housing recession is still deepening, financial conditions have deteriorated to levels not seen since the peak of the credit meltdown and most importantly consumer spending (which makes up 70 percent of the economy) is in jeopardy. Americans are suffering rising unemployment (already at 4-year highs) and cooling wage growth (at more than two-year lows) which have contributed to sentiment near three-decade lows. If spending turns out as bad as this data suggests, a recession (two consecutive quarters of negative growth) could still be in store for the world’s largest economy. Next week’s docket will give a timely reading on that front with the July retail sales report – expected to repeat June’s modest improvement.

Perhaps the dominate force behind the dollar’s ultimate long-term direction though is interest rate expectations. Despite economic data that has been less than impressive, the outlook for interest rate hikes has gone relatively unchanged. Overnight interest rate swaps show suggest the FOMC will deliver 75bps of tightening through the coming 12 months. However, to sustain such a strong rally (even with the Fed’s major counterparts looking at considerably reduced forecasts), Bernanke and fellow Board Members will need to confirm they are genuinely hawkish – and relatively soon. The longer the central bank holds its hand, the more intense doubts will grow – and looking at Fed Funds futures, it might not be soon enough. Rate expectations from the derivatives show the probabilities for even a 25bp hike has dropped from 78 percent from a month ago to 38 percent last Friday. Certainly, Thursday’s CPI reading should help clarify the outlook.

Euro Recovery May Only Be Possible On Strong Q2 GDP

Fundamental Outlook for Euro: Bearish

- European inflation risks rose as Euro-zone producer prices surged a record 8.0 percent in June
- Meanwhile, European economic growth deteriorates as Euro-zone retail sales falls 0.6 percent
- The Euro tanked on Thursday following the European Central Bank rate decision, Trichet’s dovish commentary

The Euro’s decline versus the US dollar was fast and furious last week, as the currency fell roughly 3.5 percent and below key support at the 200 SMA. With overnight index swaps now pricing in one 25bp rate cut within the next 12 months, Euro-zone economic data will become even more crucial to interest rate expectations and thus, the Euro.

This week, Euro-zone industrial production is forecasted to rise 0.1 percent June after plunging 1.9 percent during the month prior. However, with recent manufacturing PMI reports reflecting a slight contraction in output during that period, industrial production could actually be a bit disappointing.

Later in the week, Euro-zone CPI for July and Q2 GDP will be released at the same time. CPI is anticipated to accelerated to 4.1 percent from 4.0 percent, which is well above the ECB’s 2.0 percent target. Yet, it is worth noting that ECB President Trichet turned his attention to the downside risks to growth for the region last week, giving traders a reason to as well. Euro-zone GDP is forecasted to have contracted by 0.2 percent, pulling the annual rate of growth down to a more than 3-year low of 1.5 percent. The release of German GDP at 2:00 EDT on the same morning will be the best leading indicator, though, and expansion in the Euro-zone’s largest economy is anticipated to have contracted a whopping 0.8 percent for the quarter, the worst reading since Q1 1993. Clearly, economic data out of the Euro-zone points toward additional downside risk for the Euro. However, if Q2 GDP managed to eke out a positive quarterly reading, the surprise factor alone could help lift the beleaguered currency late this week.

Carry Selling And Risk Aversion Holds USD/JPY Back

Fundamental Outlook for Japanese Yen: Bearish

- Japanese Government Warns Economy May Be Heading For A Recession
- USDJPY Stands As The Holdout To A General Carry Trade Breakdown
- A Corrective Wave Stands In Front Of USDJPY’s Breakout

After weeks of congestion and building up an ascending wedge, USDJPY finally marked its major break above 108.50 last week. However, the subsequent move above 110 after the initial break seemed relatively tame compared to the major’s dollar-based counterparts. Where pairs like EURUSD and GBPUSD marked 200-300 point moves, the yen only gave up only around 75 points last Friday. Why such a significant difference? The answer to this question will likely plague the USDJPY for the next few weeks. While most traders were rightfully following the dollar’s massive rally last week, the market made another major fundamental shift: unwinding the carry trade. Concern about the health of the financial and credit markets is heating up as lending rates have deteriorated to levels that look strikingly similar to the aftermath of the subprime meltdown. Furthermore, the outlook for interest rate differentials will certainly compete with the potential for return on an increasingly risky income strategy (owing to the jump in volatility). The probabilities of a yen hike are non existent; but they chance of a cut is also approaching nil. In contrast, the high yielders (AUD, NZD, GBP and to an extent EUR) are burden with expected cuts due to expectations of a dramatic downturn in growth.

Speaking of growth, this week’s economic calendar promises to revive interest in the Japanese fundamentals. This currency is notorious for completely ignoring its own event risk; but this may not be the case with data due over the coming days; namely the second quarter GDP reading. What would already have attracted close scrutiny of its own, interest in the growth reading has been magnified ten fold thanks to the Government’s warning that there is a “high possibility the economy has entered a recession.” This is essentially the equivalent of a profit warning for the economy, but you can’t dampen this kind of risk with a mere heads up like you can in the corporate world.

British Pound Eyes Big Moves Ahead

Fundamental Outlook for British Pound: Bearish

- British Pound drops as UK Industrial Production Falls 1.6 Percent on Year
- GBPUSD Remains Steady After Bank of England Rate Announcement
- British Pound Technical Outlook shows potential for further losses

The British Pound saw its worst weekly decline against the US dollar in over 3 years, as an overwhelming greenback onslaught combined with bearish economic developments to send GBPUSD to 21-month lows. Yet pronounced drops in the euro actually left the Sterling at its highest levels in three months against its EMU counterpart, and outlook for the currency may not necessarily be as dim as recent GBPUSD price action would suggest. Our fundamental bias for the British Pound remains bearish due to a steady stream of disappointing economic data, but the coming week’s developments could potentially bring a change in the tide for the recently downtrodden UK currency.

Soon-to-be released Consumer Price Index results, UK Jobless Claims data, and a Bank of England Quarterly Inflation Report all show potential to force major moves in British Pound currency pairs. With the first major event on the ledger, analysts predict that CPI figures will show headline domestic inflation at a whopping 4.2 percent—a full 2.2 percent above the Bank of England’s target rate of 2.00. Forecasts for steady gains in inflation have thus far been unable to shift market outlook for the future of UK interest rates, but a significantly higher-than-expected result could be just enough to boost BoE rate expectations. We will certainly get a better grasp of where the Bank of England is likely to go with future interest rates in the following day’s key Quarterly Inflation Report.

Given uncertainty surrounding outlook for British Pound yields, traders will be quick to react to any significant shifts in rhetoric in the BoE’s Inflation Report. Hawkish rhetoric or any explicit mention of monetary policy tightening could be just enough to lift forecasts for GBP rates. Overnight Interest Swaps currently show forecasts of 50 basis points in BoE interest rate cuts through the coming 12 months. Given that markets predict 80 basis points in interest rate increases from the US Federal Reserve, it is little wonder that we have seen the GBPUSD slide to fresh lows. The results of the Quarterly Inflation Report may certainly drive GBP volatility, while an earlier-morning UK Jobless Claims data release could likewise drive sharp price moves on any surprises.

Swiss Franc Tumbles On Dollar Strength And Risk Appetite

Fundamental Outlook for Swiss Franc: Bearish

- Swiss Unemployment Fell in July keeping the jobless rate at 2.5% As Increased Asian Demand Spurred Hiring.
- SVME-PMI fell to the Lowest Level In Three Years in July With A Reading of 54.1 From 54.9 the Month Prior.

The Swiss Franc like most major currencies fell against the greenback as falling oil prices and declining economies in Europe and Asia led to broad based Bullish dollar sentiment. Crude falling below the technical significant $120 level sparked risk appetite and dollar strength which had the Fran trading heavy early in the week. However, it was President Trichet’s hawkish comments that would send the Franc up nearly 500 points.

Oil now trading below $118 a barrel has led to a month long slump in commodities. Declining raw material and gasoline costs have increased the profit out look for retailers and fueled risk appetite, which will continue to weigh on the Franc. Also, the fundamental picture in Switzerland is expected to decline further as the SECO Consumer Climate indicator is anticipated to fall to -4, which would the first negative reading since October 2005. The slowing growth in the economy and the anticipated effects of the U.S. credit crisis has dampened sentiment, which could see domestic growth fall. Swiss consumer have remained resilient with retail sales increasing 9.4% in May, but declining confidence could lead to shoppers tightening their wallets. There lies some technical resistance ahead for the USDCHF at the 1.0864 price level of the 61.8% Fibl level of the 1.1626 – 0.9641, which may be the only speed bump for the pair.

Canadian Dollar Pummeled By Weak Oil, Labor Market Data

Fundamental Outlook for Canadian Dollar: Bearish

- USD/CAD jumped on Friday as the Canadian employment change plunged by 55,200
- Canadian business activity slowed in July as Ivey PMI fell to 65.5

If last week’s employment data and Ivey PMI are any indication of things to come, this week’s Canadian economic data could be disappointing. On Monday, Housing Starts are expected to ease back to a seven-month low of 210K from 217.8K. Interestingly enough, the low we saw seven-months ago of 184.7K occurred during the same month that we saw disappointing Ivey PMI and employment numbers. It remains to be seen if that was simply a coincidence or if a slowdown in business activity and hiring activity has a direct correlation with housing demand. Though it was likely happenstance, there is still downside risk for this particular release.

Meanwhile, the international merchandise trade balance is anticipated to rise to a surplus of C$5.8 billion from C$5.5 billion, as export demand from the US remains robust. On the other hand, manufacturing shipments are expected to slow to a 0.9 percent pace of growth, down from 2.7 percent. However, if export figures prove to be stronger-than-expected on Tuesday, there will be greater potential for the shipment figures on Friday to improve as well. Traders should also keep oil prices in mind, especially given the sharp drop in crude to nearly $115/bbl on Friday, as extensive moves tend to be followed by retracements. Nevertheless, significant resistance for USD/CAD does not come into play until 1.0795/1.08, leaving additional upside potential for the pair this week.

Australian Dollar Looks Weak, But a Correction is Likely

Fundamental Outlook for Australian Dollar: Bearish

- The Reserve Bank of Australia held interest rates at 7.25% but signaled cuts were coming next
- Australian Employment Change doubled expectations, delivering 10.5k jobs in July

The Australian dollar lost -5.14% against its US counterpart last week. The initial selloff began as RBA Governor Glenn Stevens changed gears to signal the bank’s bias is now towards cutting interest rates. The bearish push gained momentum as the greenback staged an impressive rally against the G10 and nearly every other currency.

Looking ahead, July’s NAB Business Confidence will probably continue lower having declined to the lowest since 2001 in June as economic slowdown at home and abroad drives demand expectations lower. Westpac’s Consumer Confidence may correct a bit higher in August as Australians begin to factor in the preceding month’s near-22% drop in crude oil prices. The same dynamic will be in play for Consumer Inflation Expectations: the markets saw back-to-back readings at 5.9% in June and July, with some easing possible in the August report.

On balance, AUDUSD price action is likely to follow the majors and continue being driven by US dollar sentiment. A lucrative yield gap was the last source of the strength for the antipodean currency, and the new dovish tone coming from the RBA puts underlying fundamentals on the side of Aussie weakness. That said, the dollar looks a bit overextended following last week’s momentous moves and a retracement seems likely. Indeed, DailyFX Currency Strategist John Kicklighter has pointed out that the US Dollar Index has yet to test resistance at the bearish trend line in place since late 2005. To that affect, AUDUSD may see some strength as the greenback gives back a bit of ground in the coming days, with the downtrend to resume shortly afterward looking to take the pair beyond recent lows.

New Zealand Fundamentals Yield To US Dollar Sentiment

Fundamental Outlook for New Zealand Dollar: Bearish

- New Zealand’s Employment Change surprises sharply to the upside, tops second-quarter expectations by 1%
- The ANZ Commodity Price Index improved to print at 1.8% in July, the highest in three months

This week’s economic calendar is unlikely to offer much support to the beleaguered Kiwi dollar. Second-quarter Producer Prices will most probably tick higher as the data will not take into account July’s sharp downward correction in crude oil. The same considerations will guide the Retail Sales figure: receipts fell to the lowest level since 1997 in the first quarter and are likely to deteriorate further before cheaper oil and easing borrowing costs show up in the data for the three months to September.

Business NZ’s Purchasing Manager Index sank to the lowest levels since 2005 in June, with no substantial changes in underlying conditions to offer an improvement in July. Consumers are likely to lead businesses in offering a favorable response to falling energy costs: prices at the gas pump are more flexible than those faced by firms as they typically try to hedge against significant changes in production costs by locking in prices months in advance.

On balance, NZDUSD price action is likely to see a similar dynamic to that discussed above for the Aussie dollar. The Kiwi led most other pairs in its decline against the greenback and may do so again for the eventual correction. While the underlying fundamentals a positioned for the smaller antipodean currency to continue its decline, a bout of profit-taking on US dollar long positions is likely to see NZDUSD move higher in the near term before returning to trade with the overall bearish trend.

David Rodriguez is a Currency Analyst at FXCM.