Fundamental Outlook for US Dollar: Bullish

- US Dollar surges to 6-month highs against Euro
- Japanese Yen and US Dollar surge on financial risk aversion
- January effect in the S&P 500 points to US Dollar gains in 2010

The US Dollar was far and away the best-performing G10 currency on sharp losses in the US S&P 500 and broad deterioration in financial market risk sentiment. A positive surprise in highly-anticipated US Q4 GDP results likewise helped boost the low-yielding Greenback, and the currency now boasts three consecutive weeks of fairly substantial appreciation against the Euro. Given previous bearish extremes in US Dollar sentiment and positioning, we have frequently argued that the otherwise-downtrodden currency could stage a major comeback through the new year. Already we see that both the Euro/US Dollar and S&P 500 have posted significant declines on the month, and the January Effect in stocks and currencies points to further Greenback appreciation into February and beyond.

The first week of February likewise promises a great deal of economic event risk, and forex options markets have priced in considerable price moves in the days ahead. The critical question is whether the US Dollar will react positively to better-than-expected data or instead respond to cues in the S&P 500 and other measures of financial market risk sentiment. Traders will get their first clue on the results of Monday morning’s US Personal Income and Spending as well as ISM Manufacturing survey results in rapid succession. Consensus forecasts call for modest pullbacks in Income and Spending growth in December, while domestic Manufacturers are likely to report slower gains in activity for January. Substantive surprises in either release could easily force US Dollar moves, but the true fireworks may wait until later-week ADP Employment Change, ISM Services, and US Nonfarm Payrolls releases.

US Dollar traders will pay extremely close attention to surprises in NFPs results, while earlier ADP and ISM numbers will likely shape consensus estimates for the monthly employment figure change. Economists currently predict that the US labor market added a net 13,000 jobs through the month of January, but the monthly figures are notoriously difficult to predict, very volatile, and prone to major revisions. Suffice it to say, most analysts often question the flawed report’s relevance to the US Dollar and other major asset classes. Yet traders respond to the data at hand, and any significant surprises in earlier ADP Employment and ISM Services Employment Index figures could easily set the stage for similar surprises in clearly market-moving Nonfarm Payrolls numbers.

Current market conditions make it extremely difficult to predict price action a day ahead and much less a week in advance. Yet recent momentum clearly favors US Dollar appreciation, and our research on the “January Effect” for currencies and the S&P strongly suggest that the Dollar could finish the year considerably stronger against the Euro and other major counterparts. What happens between now and December, however, is anything but clear. Shorter-term traders should keep a close eye on the S&P and other risk barometers surrounding major news events out of the US and other large economies. We remain bullish the US Dollar on the Euro’s break below 1.40, but sharp Greenback gains warn that a very-short-term correction is possible.

DailyFX provides forex news on the economic reports and political events that influence the forex market.