US Dollar Finally Breaks Down, but Further Losses Might Need to Wait

Fundamental Forecast for US Dollar: Neutral

• US Dollar plummets as Fed hints at QE3
• Suddenly-downtrodden Greenback nonetheless fights back at key support
• Forex market volatility continues near five year lows – how do we trade?

The US Dollar (ticker: USDOLLAR) posted its single-largest weekly decline against the Euro in six months, hounded by speculation that the US Federal Reserve would soon implement a fresh wave of Quantitative Easing (QE3) and tumble in US Treasury Yields.

Official commentary from the US Federal Open Market Committee sent the US Dollar sharply lower as FOMC officials candidly discussed a fresh wave of monetary policy easing (QE3). Traders immediately increased their bets on large-scale asset purchases, and US Treasury yields fell sharply on the likelihood that Fed would work to keep interest rates depressed.

A relatively empty economic calendar for the week ahead suggests that further USD tumbles are relatively less likely. But what could potentially force the US Dollar to defy expectations and continue lower against the Euro and other FX counterparts? The second week of September may bring the next market-moving catalyst on the scheduled US FOMC rate announcement, a European Central Bank monetary policy decision, and a potentially critical German ruling on the legality of the European bailout plan.

In the meantime, there is modest risk that next week’s Economic Policy Symposium in Jackson Hole could bring important announcements from Fed Chairman Ben Bernanke and ECB President Mario Draghi. Bernanke famously used his 2010 speech at Jackson Hole conference to say that the Fed was prepared to provide further accommodation—all but guaranteeing the second wave of Quantitative Easing (QE2). Recent FOMC rhetoric may take the surprise factor off of any Fed announcements, but it will likewise be interesting to listen to the ECB’s Draghi on the future of the bank’s intervention in sovereign bond markets.

The Dow Jones FXCM Dollar Index finally broke out of its 3-month consolidative range, and we’ll admit that the movecaught us by surprise given our earlier forecasts for further range trading. To paraphrase a popular quote in finance: when the facts change, we change. And we would change our minds and shift our US Dollar bias, but the truth is that the facts are mostly the same.

Implied volatility expectations from FX options prices are still near five-year lows—making big currency moves unlikely. We would further argue that major macroeconomic risks to the Euro Zone and the dangers of sharp slowdowns across the world’s most important economies should favor the safe-haven US currency.

Seasonal tendencies suggest that currencies are most likely to set monthly highs and lows in the first and last week of each month, and that pattern could see the US DOLLAR break its month-to-date lows in the week ahead. Yet it will likely take a much larger catalyst to force a more significant breakdown. We’ll remain on alert for unexpected developments out of Jackson Hole, but it might otherwise be another week of directionless summer trading.

Happy Trading

Terry B.