Fundamental Forecast for the US Dollar: Bullish

The US dollar finished 2010 on a weak note, falling against all G10 currency counterparts in the final week of trading. Yet the Greenback is poised for a potential reversal into the New Year if we see resumption in its aggressive reversal from previous lows. A return to full market participation and a stacked economic calendar could make for particularly sharp moves in the days ahead. The first week of the month tends to set the pace for subsequent weeks, and January quite often sets the pace for the rest of the year. Thus it could be a particularly pivotal week of price action for the US dollar and trends for 2011 and it will be important to watch for breakouts in key pairs.

Top-tier economic event risk promises sharp financial market moves in the days ahead, but how the US dollar might react is admittedly anyone’s guess. The headline data release will be Friday’s US Nonfarm Payrolls report, and earlier-week FOMC Minutes, ISM Manufacturing and Services numbers, and ADP Employment Change results could likewise spark major moves in USD pairs. We have said it before and we will say it again: it has never been especially clear how the US dollar will react to positive and negative surprises in labor market data and other key growth figures. On the one hand, positive economic data should boost the appeal of US Dollar-denominated investments and drive USD gains. On the other, the Greenback remains negatively correlated to financial market risk sentiment, and any rallies in the US S&P 500 could lead risk-driven declines in the dollar.

Rather than speculate on the potential outcome and impact of admittedly unpredictable economic data, it seems more important to take perspective on the state of financial markets heading into the New Year. The US dollar starts the year on the back foot as the US S&P 500 registers fresh multi-year highs, while the lure of hard commodities and other investments has likewise put downward pressure on the US currency. Yet a number of important risks to financial markets warn against chasing gains, and one gets the sense that any number of catalysts could force important pullbacks in ‘risk’ and rallies in the dollar.

At the end of the day, we will defer to important seasonal tendencies in FX markets and will likely wait until the end of January before making more forceful US dollar forecasts. Yet risks are shaping up in favor of Greenback strength, and traders should watch for any early signs of financial market tensions headed into the New Year.

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