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US Dollar Risks Major Bearish Reversal after Worst Drop in 4 Months

US Dollar Risks Major Bearish Reversal after Worst Drop in 4 Months

John Kicklighter,

Fundamental Forecast for Dollar: Bullish

  • The USDollar dropped 0.9 percent this past week – its worst performance since the opening week of June
  • Market rate expectations are almost completely deflated, and a rebound in risk trends is more likely to revive speculation
  • Find help with your trades and trading strategy from DailyFX analysts with DailyFX on Demand

The Dollar suffered its worst stumble in four months this past week and technical traders recognize the unstable ground the currency currently stands on. The risk of a more critical break and move lower is palpable for a benchmark that has generally climbed for four years. Given the erosion in US rate forecasts and the flagging demand of haven assets – the fundamental pillars that lifted the Dollar to its current elevation – it would seem the ground is about to give way. However, the unique fundamental position the market has put the currency in will likely revive the bid before the bears are given room to run.

In the past six months, interest rate expectations have transitioned from charging the Dollar higher to anchoring congestion to sparking abrupt declines. At the beginning of the year, the clouds of QE3 were lifting and the conversation of rate forecasts teased rate watchers from a long hibernation. Through the first half of the year, a ‘mid-year’ hike left the Fed virtually unmatched for carry interest. As that loose deadline approached, the market began its current trend of discounting forecasts of a near-term move which in turn capped the currency’s climb. As of this past week, Fed Fund futures were pricing in an 8 percent chance of a hike on October 28 and 37 percent probability come December 16.

Going by the market’s estimate, the first quarter-percent increase isn’t entertained until June of next year. That leaves relatively little premium to further wick away from the Dollar’s forecast. To materially downgrade the Fed outlook from here, we would need to see will for a hike at any time in the future evaporate; and that is highly unlikely. More likely, the current level of skepticism is likely too high. The central bank has made a concerted effort to present a consistent voice to the market in order to acclimatize investors to an important transition ahead. According to their recent forecasts, we still have 13 of 17 FOMC members expecting a hike sometime this year and their rhetoric has not softened this level of conviction.

Heading into the new trading week, it will be important to assess the standing of rate speculation and establish its potential for change. Though there is little room to further deflate the market’s expectations, there is a considerable discount that can be retraced if the speculative ranks recognize the Fed is not backing down. Convincing speculators has proven difficult, however, so short of the policy meetings themselves; distinctive catalysts are needed. A range of Fed speeches is scheduled, but their consistency in warning of a nearer liftoff than traders account for only slowly works away at the incredulity. The scheduled consumer inflation figure (CPI) will carry a little more punch. A weak figure will likely just fold into current pricing while an uptick will tease a dollar bid.

Where deflated rate forecasts have pushed the Dollar to its current holding pattern, the next leg will likely find its impetus through general sentiment trends or weakened counterparts. The Dollar has enjoyed a modest haven premium over the past months, but we have not truly seen its safety appeal in full display – as is established by the lingering positive correlation to the S&P 500. If the troubles itemized by central banks, policy makers and investors (global growth, emerging markets, China) flare up; we will see the Dollar catch that bid. If they improve, justification for a delayed Fed hike will evaporate.

Perhaps the most active source of strength for the Greenback in the immediate future though is a weakened backdrop for its largest counterparts. This past week, we have seen the ECB warn of weaker inflation forecasts, the market bolster its expectations of a QQE upgrade for the BoJ in 2015 and the outlook for the BoE’s hike move the end of 2016. FX is a relative field. When the Dollar’s alternatives are looking at a neutral or outright dovish bias it reminds us that in the land of the blind, the one-eyed man in king.

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.