Fundamental Outlook for US Dollar: Bullish

- US Dollar gains traction as carry trade takes a hit
- Consumer Price Index Falls for First time since 1955, US in Deflation?
- S&P 500 rallies hurt US dollar, but outlook depends on future risk trends

The US dollar gained despite the sixth-consecutive week of S&P 500 rallies, breaking its correlation to safe-haven flows and confounding forex trading markets. Fairly steady improvement in global financial market conditions has arguably decreased the US dollar’s sensitivity to major risk barometers. Yet a single week’s results hardly signals that risk tides have truly turned, and there is little reason to believe that recent developments reflect a permanent shift in the US dollar’s trading dynamics. The 20-day correlation between the Euro/US dollar and the S&P 500 now stands at its lowest levels since January—at which point market sentiment took a sharp turn for the worse and the US dollar rallied sharply. The two situations are far from identical, but overall economic headwinds would suggest that global financial crises are far from over. A turnaround in the S&P 500 and other key risk barometers would likely force US dollar appreciation against the Euro and other major counterparts.

The Euro/US dollar’s recent break to the downside certainly improves US dollar outlook, and a relatively empty week of economic event risk suggests that currencies will largely trade off of technicals and risk-related flows. Economic calendars are sparsely populated with largely second-tier data releases. Possible exceptions include US Existing and New Home Sales reports and subsequent Durable Goods Orders data. Overall trends clearly show that the domestic economy remains in recession, but traders remain on the lookout for so-called “second derivative” improvements. In mathematics the “second derivative” is the rate of change in change. In this case, overall growth levels are clearly negative. A second derivative improvement would imply that the rate of contraction slows—thereby making way for a reversal in negative growth rates. Economic bulls cite the recent pickup in US Home Sales as early signs of “second derivative” changes, but it is far from clear that early signs of recovery will be sustained.

We will pay close attention to US Home Sales results, but we maintain that currencies are more likely to move off of broader financial market developments. If the US dollar regains its tight correlation to risky assets, it will be most important to watch movements in the S&P 500 and other key risk measures. Given six consecutive weeks of advances, we believe it is only a matter of time before we see a sharp correction in domestic equity markets.

David Rodriguez is a Currency Analyst at FXCM.