US Dollar Likely to Fall as December Favors S&P 500 Strength

Fundamental Forecast for the US Dollar: Neutral

• US Dollar rallies on heels of ECB decision, but later price action mixed
• Technically speaking, the USDOLLAR could be bought on a breakout
• Forex trading sentiment suggests US Dollar could slip further versus Euro

The US Dollar finished the week almost exactly where it began, trading within an impressively volatile yet directionless range. An effectively empty US economic calendar meant the Greenback traded off of fast-shifting developments in Europe; European leaders failed to produce a truly groundbreaking agreement on fiscal crises and the Euro/US Dollar exchange rate was virtually unmoved. A busy economic calendar in the week ahead suggests the USD may see further sharp intraday moves, but we view major breakouts as unlikely on low FX options market volatility expectations and what is typically quiet price action into late December.

Traders should track surprises in US Advance Retail Sales data, a Federal Open Market Committee meeting rate decision, and Consumer/Producer Price Index inflation results. Expectations point to fairly uneventful economic data releases, and the US FOMC is exceedingly unlikely to announce any shifts in policy. Of course that means that any unexpected results could force sharp reactions from financial markets and the US Dollar. Yet we won’t buck the trend and expect that currency markets will remain relatively quiet.

Yet what could force the dollar beyond its recent trading range against the Euro and Australian Dollar? Ongoing fiscal crises across the Euro Zone have been enough to push the EURUSD to multi-month lows. Yet large speculators have sold aggressively into Euro weakness and we see signs that fresh EURUSD declines are fairly unlikely. Recent CFTC Commitment of Traders data shows Non-Commercial futures traders near their most net-short EUR since it bottomed near the $1.20 mark in mid-2010. Given extremely one-sided positioning, we view that many traders may look to cover their short positions before the illiquid year-end trading period and push the EURUSD higher.

But what of real fundamental risks to the Euro and the lack of confidence-inspiring action from the much-anticipated EU summit? Clearly there remain serious risks to Euro Zone economic and political stability, and the safe-haven US Dollar stands to gain on further market turmoil. Yet traders and markets are often at their most bearish near market bottoms and bullish near market tops. It would likely take a substantial deterioration in Euro Zone tensions to force a news-driven EUR breakdown and US Dollar break higher. Once markets clear out part of the overhang in EURUSD short positions, then the broader downtrend could resume.

Our DailyFX Volatility Indices, which measure implied volatility expectations from FX options markets, have continued to trend lower after hitting near multi-year peaks in September. Combined with the fact that the month of December has historically been fairly quiet, and we’re likely gearing up for further directionless price action through the coming weeks.

From a pure seasonality basis, the month of December tends to be kind to the US S&P 500 and broader risky asset classes. A 30 year study shows the S&P has strengthened 23 times in December—an impressive 77 percent rate. There’s hardly a guarantee that the index will finish higher by month-end, but a strongly negative correlation between the S&P 500 and US Dollar leaves us bearish the US currency on the seasonal tendency.

It seems imprudent to be positioned in favor of US Dollar gains when COT data shows markets may have reached a bullish sentiment extreme and the S&P 500 stands to gain on historical seasonality trends. - DR