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US Dollar Could Surge if Dow Resumes Tumbles

By , Quantitative Strategist
12 August 2011 23:48 GMT
us_dollar_volatility_dow_tumbles_body_Picture_5.png, US Dollar Could Surge if Dow Resumes Tumbles

US Dollar Could Surge if Dow Resumes Tumbles

Fundamental Forecast for the US Dollar: Bullish

A week of incredible financial market volatility left the US Dollar relatively unchanged against major world currencies, and traders are braced for what promises to be another eventful week of price action. Economic event risk is relatively light, but the S&P 500 Volatility Index (VIX) trades near its highest since the financial crisis of 2008/2009 and underlines trader fear amidst great uncertainty.

The Dow Jones Industrial Average saw a record 4 consecutive days of 500-point swings and yet finished the week just narrowly lower. The Dow Jones FXCM Dollar Index saw similarly large shifts and yet traders seem unsure of the next big move. The most liquidly-traded currency pair in the world (Euro/US Dollar) remains in an astonishingly narrow 3.3 percent range since mid-July, and one gets the sense that a major break is imminent. Yet it will be critical to monitor financial market sentiment in the days ahead and whether we see resolution amidst such pronounced market volatility.

Traders will obviously keep their eyes on the Dow Jones Industrial Average and S&P 500, but event risk will be relatively limited and leaves few reference points by which to predict major swings. Volatility expectations are nonetheless riding high and fireworks are virtually guaranteed.

We would normally say that late-week US Consumer Price Index inflation figures could drive substantial volatility as markets anticipate the US Federal Reserve’s next monetary policy moves. Yet the Fed made itself plainly clear in declaring that interest rates will remain at record-lows of 0-0.25 percent through 2013. The Federal Open Market Committee’s announcement should have theoretically removed a key piece of uncertainty surrounding the US Dollar and broader dollar-linked assets. Yet the opposite happened following the FOMC’s decision—stocks fell sharply in the immediate aftermath and volatility reigned supreme. We honestly do not know what could restore order to financial markets if such a brazen statement failed to ease trader fears.

Currencies for their part remain comparatively tame, and one gets the sense that one of the markets is ‘wrong’. That is—either stock market traders are pricing in too much uncertainty or currency traders are too lax amidst considerable financial market risks. If forex traders are under-pricing volatility, we could see considerable deleveraging across key currency pairs and sharp exchange rate swings. This is especially true for the highly risk-sensitive Australian and New Zealand Dollars. Recent CFTC Commitment of Traders data shows that Non-Commercial traders remain near their most net-long the NZDUSD in history, and a sudden flight to safety could spark a pronounced US Dollar short-covering rally.

A study of historical volatility on the US stock market shows that recent price swings typically precede important market bottoms OR much larger declines. Obviously it is critical to know which is more likely, but it is likewise anyone’s guess. This author believes that the stock market could see much sharper drops before any real recovery, and the US Dollar stands to gain on any such moves. Yet the coming week may prove pivotal, and it will be important to watch the next market moves given such indecision. - DR

Find more in-depth research on the Dow Jones FXCM Dollar Index on our dedicated US Dollar Analysis Page.

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12 August 2011 23:48 GMT