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Dollar Bullish Outlook Will Need to Shift from Rates to Volatility to Continue

Dollar Bullish Outlook Will Need to Shift from Rates to Volatility to Continue

US Dollar Fundamental Forecast Talking Points:

  • The DXY Dollar Index advanced for a third consecutive week through Friday, managing a technical clearance of well-formed three-month descending trend channel
  • While there were multiple factors supporting the Greenback’s climb, it seems as if Fed rate expectations bolstered by the Powell then NFPs then CPI was the principal driver
  • There is potential for interest rate expectations to climb even further, but the Dollar is in the early stages of a recovery; so a more potent charge may be necessary – like ‘fear’
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How to Trade EUR/USD
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Fundamental Forecast for the US Dollar: Neutral

The US Dollar is the world’s most liquid currency – and by some measures the most liquid asset overall – which finds it at the center of the most elemental fundamental themes. The Greenback reflects economic potential, financial stability and monetary policy trends both for the United States and the world at large in many cases. That position tends to link the currency’s fundamental course to core themes that are more readily observable – so long as you can shift to the big picture perspective. Between the DXY Dollar Index’s peak in mid-September through the lows developed in the beginning of this month, the slide in the benchmark’s value seemed a combination of factors: a natural pullback after a nearly two-year climb; a plateau in interest rate premium and a recovery in speculative sentiment. After retracing more than half of the aforementioned climb in the span of four months, it would seem that two principal themes remain at the helm. From that 101 low, a series of events tied to interest rate expectations made for a straightforward deduction as to what was driving the markets. From the aftermath of the FOMC rate decision on February 1st to the release of January NFPs on the 3rd to the same month’s CPI update this past Tuesday, there was a progressive boost to interest rate expectations that showed through in yields and Fed Funds futures. Below is the implied yield from the August Fed Funds futures contract which bears the highest figure in the search for a ‘terminal rate’.

Chart of DXY Dollar Index Overlaid with Implied Fed Funds Rate in August and 20-Day Correl (Daily)


Chart Created on Tradingview Platform

With a 20-day rolling correlation between the moves of the DXY Dollar Index and the implied yield from the August Fed Funds futures contract at an extraordinary 0.95 (a very strong, positive relationship), it would seem that this would be the conduit to follow for further movement in the currency. That said, there are some considerations as to the potential of this theme. While possible for the market to grow even more hawkish on its Fed projections, it is already at a premium to the official consensus and the fear over a monetary policy-driven recession would act as a counter ballast. If anything potential is significant for a drop in rate expectations and thereby skew towards a bearish risk, but key rate-related catalysts are thin until Friday’s PCE deflator (which the markets don’t seem to take as seriously as the Fed) and then the March 22nd FOMC update. In contrast, the ebb and flow of speculative appetite is always capable of lightning bolts out of the blue. The Dollar is considered a safe haven currency, which means it tends to move in inversely to the S&P 500…or inline with the VIX volatility index. Though the VIX has picked up modestly this past week, it is just off yearly lows. It’s possible that volatility can continue to contract (pulling Dollar down), but it would more likely happen in a slow and choppy manner. Alternatively, the upside for a swell in fear (and Dollar bolster) would have significant upside and tends to unfold more aggressively.

Chart of DXY Dollar Index Overlaid with VIX Index and 20-Day Correl (Daily)


Chart Created on Tradingview Platform

Though it is possible – perhaps even probable – that unexpected headlines stir the market’s view on US rate expectations and broader speculative appetite, there is not much you can do to scope scenarios around the unknown. From the scheduled economic docket, there are highlights that are worth watching for their influence over the deeper currents. First thing in the week ahead, we have the absence of US market liquidity Monday owing to the President’s Day holiday. Most likely that absence of the largest market in the world from the collective pool will curb speculative intentions, but thinned liquidity can also inadvertently amplify volatility – speaking to that positively correlated element for the Dollar. On Tuesday, the focus will be on economic health either through the Walmart earnings preopen or US PMIs for February. The latter is a good, timely proxy for GDP; but the market hasn’t given it much weight in that capacity through significant movement. The FOMC meeting minutes Wednesday may tweak rate speculation, but the more capable rate speculation tool would be the PCE deflator on Friday. The Fed’s favorite inflation indicator can deviate from the CPI, but its record for market movement is notably tepid.

Top US Macro Event Risk Next Week


Calendar Created by John Kicklighter

Among the many Dollar-based crosses that are worth following in the week ahead, the most indicative for me is the EURUSD. This is the most liquid cross and in turn represents the principal representation of the DXY trade-weighted index, but the contrast from the Euro can help anchor its price developments to core fundamental views – in other words: it can more readily suppress errant volatility. The interest rate differential consideration here is perhaps amplified because the ECB is one of the few major central banks for which there is general ambiguity as to where it will ultimately cap its tightening regime given it is behind its major peers. Alternatively, the ‘risk’ to ‘haven’ contrast in this cross is far smaller than a pair like USDJPY or AUDUSD. Therefore, if there are seemingly sentiment-oriented breaks in other Dollar-based pairs, it would be beneficial to seek confirmation from EURUSD.

Chart of EURUSD with 20 and 100-Day SMAs (Daily)


Chart Created on Tradingview Platform

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