US Dollar: Will the Greenback’s Rally continue into the New Year?

US Dollar: Will the Greenback’s Rally continue into the New Year?
The US dollar was able to recoup some of its losses from Thursday; but the progress and speculation that has developed around the currency over this week needs to be taken with a grain of salt. In fact, perhaps the dollar’s December rally should be reevaluated when developing forecasts for the opening weeks of 2010. It isn’t difficult to find evidence of the currency’s strength through the past month. On a trade weighted basis, the dollar reversed a brutally consistent seven-month descending trend channel and recovered from 16-month lows. Across the majors, the same strength was evident. The leader for liquidity, EURUSD finally reversed course on its steady bull trend and plunged over 900 points. Taking a bigger picture look at GBPUSD, the pair certainly recorded greenback strength but within the confines of a broad seven-month trend. And, perhaps the most remarkable performance would come from USDJPY. While market-wide yen selling no doubt contributed to the major’s advance, the pair swung from 14-year low to three-month high in the span of just five short weeks.

As traders, we are less concerned with where the market has been and more interested in determining where it will go; but in this move we can establish a few meaningful questions that can guide our forecasts. First of all, we have to establish that the primary fundamental drivers for the currency remain: underlying risk trends; its status as a funding currency; and relative interest rate expectations. I have been bullish on the US dollar for some time; but on reflection of these broader fundamental drivers, the greenback has made little fundamental progress on any of the three. Investor sentiment held strong through the end of the year (as seen in the Dow’s buoyancy); US funding is still the cheapest among its most liquid peers; and the potential for a timely Fed rate hike was actually tempered through the final quarter. So, if all of these bearish factors are still in place; why did the US currency rally? To maintain a push to new extremes for any financial instrument (whether it be 16-month for EURUSD or 14-years for USDJPY) requires fundamental moment. All of these aspects may still exist; but they are not being fed by the influx of sidelined capital that bolstered risk appetite with reckless abandon throughout 2009. Moreover, stalled confidence further encourages profit taking before the year’s end. Now, looking ahead to a new year; the dollar still looks to benefit should risk appetite collapse, US market rates rebound or the Fed signal it is ready to return to a hawkish regime. However, should all of these trends remain, the dollar’s December rally may prove a brief reprieve in a larger trend.

Reducing our scope for fundamental action, there will be plenty of event risk to work with when liquidity fills back out next week. Without doubt, top event risk throughout the period is Friday’s NFPs. We have seen a consistent improvement in trend for this series (smaller monthly losses); and it is only a matter of time before positive numbers are once again posted. And, while there is an argument to be made that the overall level of joblessness is still very high and will likely remain that way as the economy struggles to find its footing; speculators are a forward looking crowd and will likely respond positively to such a milestone. Among the other notables for the week that should be monitored: ISM manufacturing and services figures will offer a rounded gauge of business health; consumer credit will offer a look into two critical factors of economic health (lending and spending); and construction spending will prove just how strong the housing market’s recovery is.

Related: Discuss the US Dollar in the DailyFX Forum, Top 5 Events for the Week of January 4

Euro Struggles to Revive Strength, Can Next Week’s Event Risk Help?
Where the dollar would finish the year strong, the euro would tumble through the end of the truncated week. One reason for this weakness is the euro’s status as the primary alternative to the US dollar – a trait that has clearly worked against the former currency over the past month. However, the currency’s weakness can just as readily by attributed to its own fundamental short-comings as exogenous factors. Growth in certain Euro Zone member economies has fed bullish expectations; but as a whole, the region is struggling in its economic and financial recovery. What’s more, the ECB has offered no sign that it will pace a global return of rate hikes in 2010. Looking ahead to next week and year, it will be difficult to shake the specter of a stalled economy and mired credit market; but fine-tuning interest rate expectations is certainly possible. Among notable releases that policy makers and traders will be watching, the Euro Zone CPI estimate, German unemployment change and regional sentiment readings hold the greatest potential.

Related: Discuss the Euro in the DailyFX Forum

British Pound Finishes the Year Strong on Housing Data
The pound rallied hard for a second day Thursday, pushing the currency to significant levels against its US, European and Japanese counterparts. However, this last push before the market tunes out may struggle to find momentum when larger-term fundamental trends are back on track. Today’s event risk offered a small sign of hope for the struggling UK economy. The Nationwide House Prices indicator rose for an eighth month with a 0.4 percent increase for the month of December. Economists for the group ascribe the increase in prices to the lack of supply in the market; and this data further confirms last week’s BBA report that mortgage lending is near a two-year high. Yet, the United Kingdom’s problems run deeper than simply patching the housing sector. Consumer spending is still absent, the possibility of a political regime change threatens to snuff the progress that recent policy has afforded and lending is anemic. To maintain the sterling’s nascent recovery, the market will require something tangible to grasp on to. We may find just that in next week’s economic listing as the Bank of England deliberates its policy stance. No change is expected for the benchmark lending rate; but watch for changes to forecasts in commentary or a possible adjustment to the size of the bond purchasing program. Speculators are sensitive to even slight changes in policy; and such adjustments would be far from subtle.

Related: Discuss the British Pound in the DailyFX Forum

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Written by: John Kicklighter, Currency Strategist for DailyFX.com
E-mail: jkicklighter@dailyfx.com