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Forex: Dollar Tumbles Except Against Yen, What Could Save the USD?

By , Quantitative Strategist
01 February 2013 00:56 GMT
Forex_Dollar_Tumbles_Except_Against_Yen_What_Could_Save_the_USD_body_Picture_1.png, Forex: Dollar Tumbles Except Against Yen, What Could Save the USD?

Forex: Dollar Tumbles Except Against Yen, What Could Save the USD?

Fundamental Forecast for US Dollar: Bearish

The Dow Jones FXCM Dollar Index (ticker: USDOLLAR) rallied for the third-consecutive week driven by Japanese Yen weakness, but sharpgains in the US S&P 500 meant that the safe-haven Greenback fell sharply against the Euro and other risk-friendly counterparts.

The S&P wrapped up its best performance in 15 months and its best start to the year since 1997, and a larger US Dollar rally seems unlikely amidst buoyant financial markets. The week ahead could bring important volatility on three central bank interest rate decisions, but a relatively quiet US economic calendar means that the Greenback will likely trade off of moves in the S&P and broader financial market ‘risk’ sentiment.

Investors have hit their most bullish levels on US stock markets since the onset of the financial crisis in 2007, and the so-called “Fear Index” in the S&P 500 VolatilityIndex (VIX) finished below the 13 percent mark. Why?

A bullish wave of US economic data certainly helped market mood with a dovish US Federal Open Market Committee, a relatively strong US Nonfarm Payrolls result, and a sharply better-than-expected US ISM Manufacturing data for January.

The Fed set the tone for the week as it stuck to its open-ended Quantitative Easing measures and showed little urgency in scaling back asset purchases. This stood in contrast to relatively hawkish comments from St Louis Fed President Bullard as he claimed the Fed could soon scale back purchases as unemployment edged lower. Yields on the US 10-year Treasury Note subsequently finished above the psychologically significant 2.0 percent mark for the first time in 9 months. Continued gains in yields could help the US Dollar push to fresh highs against the downtrodden Japanese Yen. Yet rising yields have not been enough to boost the USD versus other counterparts.

US NFP results showed an increase in the unemployment rate through January, but a strong upward revision to previous months of job creation helped boost US stocks and hurt the safe-haven US currency against all except the yield-sensitive JPY. ISM Manufacturing data for the same month trounced expectations and fueled the stock market rally further; strong growth in the Employment, New Orders, and Production sub-indices painted an optimistic future for industry in the United States. Amidst such clear bullishness and tremendous S&P gains, what could derail risk and potentially boost the safe-haven US Dollar?

What goes up must come down, and we can’t stress enough that markets will often look their most bullish at major tops. The plunge in the VIX seems particularly out of the ordinary given that currency market vols have jumped noticeably off of recent lows. This isn’t to say that currencies and stocks must always move in the same direction, but the stark levels of complacency in key measures of sentiment warn that the S&P 500 may be near an important inflection point. The timing of said reversal is incredibly difficult, however, and without any real catalyst we have no choice but to call for further equity market gains.

We expect the US Dollar to trade off of moves in ‘risk’ as well as upcoming European Central Bank, Bank of England, and Reserve Bank of Australia rate decisions. None of these central banks are expected to announce major changes to monetary policy, and the week will otherwise be devoid of top-tier event risk. The first full week of February trade could potentially be a quiet one, but markets feel far too complacent to take our eyes off of any number of factors that could unsettle high-flying stock markets. - DR

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01 February 2013 00:56 GMT