Fundamental Forecast for the US Dollar: Neutral

The US Dollar tumbled as the Dow Jones Industrial Average saw its biggest single-week rally in two years, limping into the first week of second half trading. Traders sent the Greenback reeling against all except the similarly low-yielding Japanese Yen and Swiss Franc. Expect similar price action from US Dollar pairs if the current Dow rally continues, but a late-week US Nonfarm Payrolls report may very well set the tone for the rest of the month and potentially the year.

All eyes turn to Friday’s US Nonfarm Payrolls report, and the US Dollar and broader financial markets could see sharp swings on the usual mix of pre-NFP data releases. The USD has fallen noticeably as soft domestic economic data and disappointing May NFP results dimmed outlook for the future of Federal Reserve monetary policy. Expectations point to similarly underwhelming June labor market growth, but dour forecasts arguably leave dollar risks to the topside on any potential surprises. As the Fed’s second wave of Quantitative Easing (QE2) comes to a close, markets will look to US employment and inflation data for clues as to when the Fed may begin to tighten monetary policy.

Domestic interest rates at record-lows mean that the US Dollar stands to lose further against higher-yielding counterparts as speculators continue to chase high returns. This means that the USD could depreciate against the Australian Dollar and New Zealand dollar in particular, while shifts in broader risk sentiment are less likely to affect the USDCHF and USDJPY. Indeed, our research shows that the US Dollar could recover against the Swiss Franc and Japanese Yen as QE2 has run its course.

Whether or not the US Dollar can stage a larger reversal will likely depend on labor market data, while Thursday’s European Central Bank interest rate decision could likewise drive sharp volatility across forex markets. The ECB is very widely expected to raise interest rates by 0.25 percent, but it will be important to watch guidance on future rate moves and effects on European markets. Given market stress over the future of Greece and other at-risk euro zone countries, any especially surprising rhetoric from the ECB could produce sharp moves across domestic markets and the euro currency itself.

Seasonality studies show that the first week of every month typically sets the pace for monthly performance, the first month of the quarter predicts quarterly performance, and the first quarter of the half often predicts moves through the rest of the period. Thus it is little exaggeration to claim that the coming week’s developments could set the tone for the rest of the year. Such factors make reactions to US NFP data especially significant, and traders should keep a close eye on any sharp surprises.

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