Fundamental Outlook for US Dollar: Neutral

- US Dollar falls as Goldman Sachs results boost S&P 500
- US Jobless Claims boost hopes that economy may recover
- US Dollar may react to Federal Reserve’s Ben Bernanke Testimony

Impressive rallies in the S&P 500 left the US Dollar lower against all major currencies except the Japanese Yen, but a relative sense of unease across financial markets highlights risks of a major USD bounce. US and European equity indices finished the week anywhere from 6-8.5 percent above their previous close—good for a 2000-3000% annualized rate of return. Early-week moves came on impressive earnings results from Wall Street titan Goldman Sachs and relatively benign economic data. It is easy to claim, however, that recent developments are unlikely to sustain such an impressive rate of returns. A relatively empty week of economic event risk ostensibly limits volatility expectation in the days ahead, but traders should keep a close watch on several key earnings reports and effects on the S&P 500 and US Dollar.

The US currency remains in a wide and choppy range against the Euro and other key currencies, and it may take a fairly significant shift in financial market risk sentiment to break the dollar from its trading channel. Had we known a week ago that the S&P 500 would break to fresh 30-day highs, we may have claimed that the EUR/USD would similarly break to fresh medium-term peaks. Yet forex markets clearly had other things in mind—constraining the heavily-traded currency pair to its two-month wedge formation. Consolidation patterns typically lead to noteworthy breakouts, but a continued downtrend in volatility expectations gives little reason to believe such a break will come in the week ahead. Indeed, the DailyFX 1-week currency volatility currently stands near 12-month lows.

The obvious question remains: What could break the US Dollar from its medium-term trading range? In short, there is no real way to know. Our natural suspicion is that it will take a substantial deterioration or improvement in financial market risk appetite to break the EURUSD below 1.3700 or above 1.4300. The rolling correlation between the EURUSD and US S&P 500 continues to trade near record-highs—emphasizing the US Dollar’s sensitivity to the key risk barometer. Equity markets remain similarly linked to the trajectory in commodity markets; the S&P – Reuters CRB Commodities Index correlation likewise trades near all-time highs. Increasingly clear connections across ostensibly unrelated asset classes underline the risk that a tumble in one will lead to sympathetic moves in another.

It remains critical to monitor the trajectory of key financial market health indicators and their effects on the US Dollar. As we continue to argue, noteworthy deterioration in financial market risk sentiment will likely be the spark to force major US Dollar rallies. Absent the correction, the Euro/US Dollar currency pair may continue to trade in a progressively narrower range.

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