Fundamental Outlook for US Dollar: Neutral

- US Gross Domestic Product numbers show worst drop in 27 years
- Dollar slipped on S&P rallies through earlier-week trading
- Months of consolidation could foreshadow US Dollar breakdown

The US Dollar finished the week lower against foreign counterparts, but it failed to break below key range-lows despite sharp S&P rallies and fairly disappointing domestic economic developments. The highly-anticipated US Gross Domestic Product showed that the economy contracted less than expected in the second quarter of the year, but noteworthy downward revisions to earlier figures clearly dampened optimism on growth. Government data showed that the economy saw its worst quarter-on-quarter performance in 27 years in Q1. The slower rate of contraction in Q2 may have calmed some nerves, but truly dismal Personal Consumption figures underlined that consumers—the engine of earlier economic growth—remains heavily subdued. The upcoming week brings infamous Non Farm Payrolls data to the fore, and it will be critical to watch for any signs that the US Dollar could finally break its range versus major forex counterparts.

Week in and week out we have discussed potential scenarios for a US Dollar breakout, but FX markets have shown little willingness to push the USD beyond its trading channel through directionless summer trade. Of course, forex market volatility tends to be mean-reverting over the medium-to-long run. Lengthy periods of consolidation most often lead to sharp breakouts, but the timing of said shift remains anything but clear. Forex options markets volatility expectations are near their lowest levels since August, 2008. Anecdotal evidence tells us that trading volumes have fallen sharply through the summer—theoretically making it easier for a big traders to force volatility. Yet few have shown the appetite for moving markets, and we anxiously await signs that the US dollar may finally break out of its consolidative range.

Can the US Non Farm Payrolls report and other key data releases finally break us from our recent range? We will certainly know the answer to this question once the coming week is through, but it is worthwhile to discuss possible scenarios in which the US Dollar could finally move sustainably higher or lower against the Euro and other key counterparts. Consensus forecasts imply that markets expect broad improvements in key NFP and similarly market-moving ISM Manufacturing and Services results. Given the general uptrend in equity markets and general economic mood, such predictions come of little surprise. Yet lofty expectations leave significant room for disappointment, and the very fact that the S&P 500 has rallied so substantially through recent weeks leaves it at risk for a noteworthy correction.

Forex futures and options data shows that traders remain extremely net-short the US Dollar, and our bias remains bullish as a result. The key difficulty remains the timing of any such correction, as market sentiment can remain at extremes for extended stretches. In other words, we know it’s all a matter of time. Given enough of it, we may expect the Greenback to finally break above the Euro 1.4350 mark or below 1.3800. Given enough time, traders will unwind extremely one-sided US Dollar short positions and bring a noteworthy correction. Whether that may be in the week ahead is anyone’s guess, however, and it will be critical to watch for signs of a sustained reversal. Said signal could come from the S&P 500 and other key financial market risk barometers.

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