Fundamental Forecast for the US Dollar: Bullish

The US dollar showed important signs of strong reversal against the euro and other major counterparts, taking honors of top G10 performer through the past week of trade. The Dow Jones FXCM Dollar Index now trades nearly 3.5 percent higher off of its recent multi-decade trough, and indeed we see evidence that said reversal could be evidence of a larger correction against what seems to be a bearish sentiment extreme.

Our proprietary Speculative Sentiment Index data shows that retail traders remained net-long the US Dollar against the Euro and Canadian Dollar since January and September, 2010, respectively. Yet crowds have now flipped net-short the Greenback as of just this week, giving contrarian signal that the dollar could continue higher through near-term trade. FX Options markets show volatility expectations are riding high ahead of what promises to be another exciting week of price action across forex markets.

Foreseeable event risk is limited with the clear exception of US Federal Open Market Committee Minutes due Wednesday afternoon. The US Dollar dropped rapidly following the FOMC’s decision to leave monetary policy unchanged through its most recent meeting. Officials showed little willingness to pull back extraordinary monetary policy accommodation in the post-decision statement and ostensibly sunk hopes for the downtrodden US currency. Yet the Greenback set its short-term bottom just days later, suggesting that markets may have seen an important bearish sentiment extreme. It remains extraordinarily difficult to accurately time tops and bottoms following such extensive trends. Yet we have frequently warned that CFTC Commitment of Traders data showed large speculators have remained heavily net-short the USD through recent months. A broad deleveraging would further force speculators to cover leveraged US Dollar-short positions and in all likelihood force further Greenback rallies.

Whether or not the Fed shows a substantive shift in rhetoric will be a major focus for the US Dollar in the days ahead, but it will be equally critical to watch moves in broader financial market risk sentiment. The Greenback carries the second-lowest short-term interest rate of the world’s major currencies. Said fact means that speculators have heavily borrowed US Dollars as a cheap funding source for higher returns in other markets and higher-yielding currencies.

Robust demand for the FX Carry Trade—where investors borrow at inexpensive rates to buy higher-yielding counterparts—explains a great deal of US Dollar weakness. Yet said strategy only works well when interest rate differentials are large enough to cover exchange rate volatility. Given high volatility expectations, many speculators have noticeably pulled back such bets. Continued corrections in broader ‘risk’ could quite easily force continued US Dollar strength.

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