Fundamental Outlook for US Dollar: Neutral

- Disappointing US Consumer Price Index data set the stage for a lackluster FOMC decision
- A shift in forex sentiment suggested that the US Dollar would lose against the Euro, British Pound
- Forex options and futures positioning likewise leaves scope for USD pullbacks

The US Dollar finished the week sharply lower against the Euro and other major counterparts amidst a sharp recovery in the S&P 500 and broader financial market risk sentiment. Last week we wrote that the US Dollar’s inability to sustain a move below $1.20 against the Euro signaled that USD bulls grew tired and further EURUSD losses were less likely. In fact, the most recent CFTC Commitment of Traders report shows that Non-Commercial traders scaled back their US Dollar longs against the Euro (EURUSD shorts) by a record amount in the week ending June 15—emphasizing the sharp sentiment shift among markets. Given downward momentum through recent trade, we suspect that the coming week could bring further US Dollar losses against the relatively resurgent Euro and other key currencies.

Whether or not the US Dollar continues its recent slide through the week ahead will almost certainly depend on the trajectory of the S&P and broader risk appetite. Said correlation to financial market sentiment will make it especially important to watch reactions to Wednesday’s US Federal Open Market Committee (FOMC) interest rate decision, while several mid-tier economic releases could force volatility on large surprises. Overnight Index Swaps show traders have priced in zero probability of an interest rate move through the announcement, but the event may nonetheless spark volatility on the attached rhetoric. Those same OIS rates show markets predict that the Fed will raise rates by a paltry 34 basis points in the coming 12 months—the lowest expectations since the Dow Jones Industrials Average traded near 8000 in the first half of 2009.

Traders clearly expect that central bank will leave rates and monetary policy stance unchanged, but any surprises could force substantial moves across financial markets. The key question may be whether the relatively hawkish minority within the FOMC becomes more vocal in their calls for a withdrawal of unprecedented monetary policy stimulus. Uneasy conditions in financial markets and relatively mixed evidence of a true economic turnaround suggest that officials will leave official commentary largely unchanged. Yet such effectively neutral market expectations may make for especially large volatility on any subsequent surprises.

Financial markets seem to have hit somewhat of a summer lull. Our DailyFX 1-week Volatility Index has seen its largest peak-to-trough drawdown since the aftermath of the Lehman Brothers bankruptcy in late 2008. The S&P 500 Volatility Index has seen similar declines, and limited volatility expectations lessen the likelihood of major market moves in the week ahead. Given relative complacency in financial markets, the safe-haven US Dollar could continue to slip lower against the Euro and other key counterparts. FX traders should nonetheless wait and see what the FOMC rate decision will bring. If there were one foreseeable event that could break the relative calm, a hawkish shift by the US central bank would likely be it.

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