Fundamental Outlook for US Dollar: Bearish

- US Dollar finishes week stronger, but bounce in DJIA cuts into USD and JPY gains
- Worst US Retail sales decline in history fails to push Dollar lower
- Speech by Fed Chairman Ben Bernanke signals hope in ongoing financial crisis

The US Dollar finished the week broadly higher against major forex counterparts, as flare-ups in financial market tensions led to aggressive buying of the safe-haven US currency. Investors sent the US Dow Jones Industrials Average briefly below the psychologically significant 8,000 mark for the first time since November, but a subsequent ease in market tensions allowed downtrodden US stocks to bounce back through end-of-week trade. The recovery was all the more impressive given the absolutely dismal string of economic developments through recent weeks. In fact, December’s Advance Retail Sales report showed the biggest single-month decline in the survey’s 20-year track record. There are few signs of hope in recent economic data, but some believe that economic stimulus plans and the US Treasury’s bailout funds will improve US fundamentals. All the same, bleak outlook for the US economy does little to boost forecasts for the dollar.

The week ahead will be relatively tame in terms of planned economic event risk, but recent experience has shown that the US Dollar may nonetheless remain volatile on shifts in financial sentiment. The sole noteworthy reports on the calendar will come on Wednesday and Thursday, with NAHB Housing Index, Housing Starts, and Building Permits reports to shed further light on the state of the domestic housing market. An outright crash in house prices was the “smoking gun” that began the ongoing global financial crisis, but some hope that a material improvement in real estate markets will boost prospects for major financial institutions that hold toxic mortgage debt. However unlikely that may seem given current economic outlook, it will be important to watch any and all housing data as it relates to markets for home mortgages.

Otherwise the US Dollar will continue to trade off of global financial risk sentiment, and a continuation of recent bearish trends would likely send the US Dollars to fresh highs against the Euro and other risk-sensitive currencies. Medium term trends clearly favor further US Dow Jones Industrials Average losses, but extremely trough-to-peak volatility makes holding short positions extremely difficult. That being said, our own research shows that 2009 Price to Earnings (P/E) ratios on the Dow’s 30 stocks are currently at their lowest levels since 1996—at which point the Dow went on to stage a massive recovery. Though we certainly will not call for a stock market bottom in the face of such sharp declines, the underlying fundamentals for stocks have arguably improved—at least as far as common valuations are concerned. Whether or not a stock market bottom translates into a US Dollar top is another matter entirely, but recent forex correlations suggest that equity market rebounds would lead to commensurate dollar weakness.

David Rodriguez is a Currency Analyst at FXCM.