Fundamental Forecast for the US Dollar: Bullish

Panic stock market sell-offs set the stage for continued S&P weakness into what promises to be a critical week for the US Dollar and broader financial markets. The S&P 500 finished the third quarter a whopping 14.33 percent below its open and marked a fifth consecutive month of declines. The last time the S&P fell five months in a row was March, 2008. At that point, stocks posted two months of strong rallies and moved nearly 15% off of their short-term low. Yet the rest was history: financial markets thereafter saw their worst crisis in the post-war period and the S&P fell over 50% from its May, 2008 peak. The US Dollar posted breathtaking rallies across the board and stands to see similar outperformance on any similar declines.

The coming week promises significant volatility on the always-anticipated US Nonfarm Payrolls report, and the first week of the month and quarter could set the tone for price action through the end of the year. It’s difficult to be optimistic about the US and global economy given the breadth of bearish economic data and little hope of any significant turnaround.

Economic forecasters predict that the US economy added a mere 50k jobs through the month of September, leaving the unemployment rate at an unacceptably high 9.1% and curtailing any real hope of a consumer-led recovery. The US Federal Reserve is likely to pay close attention to the release as financial market sentiment remains quite fragile. Yet there is limited scope for fresh Fed action following the announcement of “Operation Twist” and no real appetite for further monetary policy stimulus.

A shift towards fiscal austerity in the US legislature likewise leaves little scope for further fiscal stimulus. And really, it feels like US officials have used almost all of the tools in their arsenal to prevent a double-dip recession. What’s next? If you listen to the bearish camp, the next move will almost certainly be US economic contraction.

What does this mean for the US Dollar? Normally we would claim that domestic economic weakness would hurt any given country’s currency. Yet the Greenback is fairly unique given that investors typically treat it as a safe-haven store of value. Thus economic weakness could translate into demand for safe-haven assets and in turn US Dollar strength. We expect that the US Dollar could actually rally on a disappointment in key economic data—even the critical US Nonfarm Payrolls report.

Such economic data-led volatility is not limited to the US economy. Contentious interest rate decisions out of the Bank of England, Reserve Bank of Australia, and especially the European Central Bank could force significant moves across equity markets and currencies. Overnight Index Swaps predict a 100% chance that the ECB will cut interest rates by 25 basis points, and any disappointments could send markets reeling. Ongoing fiscal crises in Greece likewise have the potential to send markets into a spin. Markets await the next turn in the ongoing saga and its effect on the Euro/US Dollar.

It could be a make or break week for the US Dollar and broader financial markets. The first week of the month typically sets the tone for the rest of the period, while the first month of the quarter could set the pace for trading through year-end. All eyes will be on key data releases and interest rate decisions, and forex market volatility will almost certainly remain high in anticipation.

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