Fundamental Outlook for US Dollar: Bullish

- US Dollar gives up ground as Euro Zone plans Greece bailout, markets rally
- Disappointingly vague plan nonetheless sparks S&P pullback, Greenback rally
- US Dollar risks pullback in the context of a broader reversal on futures positioning

The US Dollar finished the week almost exactly where it began, confounding traders with volatile short-term moves yet remaining nearly unchanged. Similarly choppy price action in the S&P 500 underlined financial markets’ indecision and gave few clues on future short-term direction. It seems that financial markets have reached somewhat of an impasse. On the one hand, months and months of stock market advances leave more medium-term momentum to the topside. On the other, the S&P 500 and other major indices remain in a clear bear market and risk further losses following a fairly long period of appreciation. Determining which scenario is most likely is critical to establishing a clear trading bias for the US Dollar. As one of the lowest-yielding major world currencies, the Greenback often falls victim to speculative selling as traders buy higher-yielding currencies. Yet strong bouts of financial market risk aversion most often force substantive US Dollar rallies, and it remains critical to watch risk trends through short-term trading.

Options markets short-term volatility expectations on the US Dollar have pulled back in recent trade, but speculators should watch for any surprises in US economic event risk through the days ahead. Top events will start with Wednesday’s Minutes from the most recent Federal Open Market Committee rate decision to be followed by the following days’ Producer and Consumer Price Index reports. All three events threaten to force substantive shifts in market interest rate expectations and, by extension, the US Dollar.

FX traders will watch whether the FOMC gives further hints on when it may begin raising interest rates in 2010, while any especially large surprises in PPI and CPI could likewise offer clues on the trajectory of central bank rates. Fed Chairman Ben Bernanke recently outlined the steps the central bank could take to begin withdrawing massive monetary policy stimulus in an address to the US legislature. How soon those plans can be put into action wholly depends on the pace of economic recovery and trends in national prices. Recent disappointments in US Nonfarm Payrolls data would imply that the FOMC is in no hurry to tighten monetary conditions. Yet it serves to note that Kansas City Fed President Thomas Hoenig dissented in a 9-1 vote to keep the Fed Funds rate near zero for “an extended period”. Whether or not his relatively hawkish bias will gain broader traction is an important topic and it will be important to monitor the statements from the FOMC minutes.

If the Fed shows any willingness to tighten rates through the coming months or we see any substantive surprises in PPI and CPI data, the fragile US S&P 500 could break considerably lower and send the US dollar higher. Overnight Index Swaps show zero percent probability that the Fed will raise interest rates through the coming months. Stock markets rarely respond positively to higher borrowing costs, and any signs that rate hikes could come sooner could easily crimp risk sentiment. Given clear indecision across financial markets, clarification could spark the trends that most traders crave.

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