Fundamental Forecast for the US Dollar: Bearish

The US dollar fell sharply across the board on a dismal week for fundamental data out of the world’s largest economy, highlighted by sharply worse-than-expected Nonfarm Payrolls data that sparked pronounced Greenback weakness. Markets seemingly refused to buy the safe haven currency despite a two percent week-over-week decline in the Dow Jones Industrial Average. Indeed, the Greenback’s traditional role as a beneficiary through times of market turmoil seems at risk as cross-asset correlations faded into the week’s close.

An effectively empty week of US economic event risk means that the downtrodden USD will trade almost exclusively off of moves in broader markets. Yet a recent breakdown in correlations leaves outlook as anything but certain. We recently highlighted that the link between the Dow Jones Industrial Average and Dow Jones FXCM Dollar Index traded near record strength. That link nonetheless broke down as the Dollar Index fell for the third consecutive week—compared to fifth consecutive week of losses for the Dow Jones itself.

One correlation that only seems to strengthen as of late is that between the US Dollar/Japanese Yen pair and US Treasury Bond/Note Yields. The benchmark 10-year Treasury Note closed below the psychologically significant 3.00 percent mark for the first time since November on the material disappointment in US Nonfarm Payrolls data. The highly interest rate-sensitive 2-year Treasury Note likewise traded sharply lower, and broader markets clearly expect US short-term interest rates will remain near record-lows for the foreseeable future. The USDJPY unsurprisingly trades near multi-month lows and risks remain weighed to the downside through upcoming trade.

Overnight Index Swaps show expectations that the US Federal Reserve will raise its Fed Funds rate by a paltry 21 basis points in the coming 12 months—less than a third of the 76bps forecast for the European Central Bank. Cross-currency interest rate differentials are likely to continue to haunt the US Dollar at least through the coming year, and wave-after-wave of disappointing economic data will only worsen Fed outlook. Given recent disappointments in economic data, low interest rates are all but guaranteed. A key question on many traders’ minds is whether US economic data will warrant further Fed monetary policy accommodation as its controversial second wave of Quantitative Easing (QE2) expires in June.

US Dollar risks remain to the downside across the board as it seems there are few factors to drive Greenback strength. Low yields continue to punish the USD against the highly interest-rate sensitive Japanese Yen, while corrections in the US Dow Jones and broader market ‘risk’ have not led to strength in the traditional safe haven US currency. A busy week of interest rate decisions from the Reserve Bank of Australia, Reserve Bank of New Zealand, Bank of England, and European Central Bank represent the greatest foreseeable event risk.

Any significantly negative surprises for the Australian and New Zealand Dollars, British Pound, and euro could force retracements. Yet longer-term and recent momentum favors further USD weakness.

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