Dollar Could Surge as Markets on the Brink of Something Big

Fundamental Forecast for US Dollar: Bullish

• The warning signs are clear: we’re watching for further USD and JPY strength

• Japanese Nikkei plummets 7+ percent and sparks broader market panic

• We’ve said it before and we’ll say it again, it could be only the beginning the USD surge

It was shaping up to be a banner week for the US Dollar as the Dow Jones FXCM Dollar Index (ticker: USDOLLAR) powered to fresh multi-year highs, but the suddenly-resurgent Japanese Yen stole the spotlight as it posted its largest weekly gain since August, 2011. It may nonetheless be another critical week for FX and broader financial markets as we see early signs of potential turnaround in the S&P 500, the Yen, and even global bond markets.

There are countless bubbles in financial markets as global central banks attempt to inflate their way out of economic slowdown (e.g. the US Fed’s QE measures). We think two of the biggest and most obvious ones are global equity markets (see: S&P 500, Nikkei 225) and bonds (everything from AAA-rated sovereign debt to junk bonds). The past week saw both take a simultaneous nosedive, and anyone can tell you that stocks and bonds are not supposed to move in the same direction.

The fact that both US Treasury Bonds fell (yields rose) as the S&P 500 tumbled warned that market conditions are anything but normal, and it feels as though markets are on the precipice of an indiscriminate and potentially violent deleveraging. Or in plain English: if we see stocks AND bonds continue recent tumbles, it would signal market panic and likely significant US Dollar strength.

Why does this matter? We haven’t seen this kind of indiscriminate deleveraging in any real volume since the “Flash Crash” of May, 2010 and before that it was the Financial Crisis of 07/08. You can say what you will about the Dollar’s fall from grace as the world’s premier safe-haven currency, but the fact is that the Dollar has appreciated in every episode of financial market panic in recent memory. What do we watch for in the week ahead?

First and foremost, we’ll need to see whether this is truly the startof a turn in the S&P 500. Even if other markets don’t necessarily follow suit, there’s a good chance that stockmarket weakness will be enough to drive the Greenback higher. Secondly, it will be critical to watch whether we see the same sharp sell-offs in bonds and other asset markets. We’re specifically talking about the things that are not supposed to move together like the Dow Jones and the 2-year US Treasury Note. If stocks fall as government bond yields rise (bond prices move inversely to yields), the Dollar could strengthen significantly as investors unwind speculative trades in a hurry.

Why all the doom and gloom? Couldn’t this be only a minor stumble as the S&P continues its seemingly-unstoppable march towards fresh peaks? Of course—it certainly wouldn’t be the first time we were ‘early’ in our calls for a substantial market turnaround. Yet we’ve said it before and we’ll say it again: market conditions are entirely too quiet. And though it feels as though forex market volatility is already high, US Dollar volatility prices are literally a fraction of they were just three years ago. The recent US Dollar breakout could be just the beginning as FX volatility prices test critical highs.

It will be a pretty light week of major FX economic event risk with possible exceptions that include US GDP revisions and further commentary from Fed Chairman Ben Bernanke. But the past week of price action emphasizes that the catalyst doesn’t need to come from a top-tier economic calendar release. There was a 7+ percent decline in the Japanese Nikkei 225 index that was ostensibly caused by disappointing Chinese PMI data. But if you really believe that a minor disappointment in an industry survey was enough for a near-crash in markets, I’ve got a bridge I’d like to sell you.

Traders are nervous as we see the early signs that markets might unravel. And though the risk of overnight economic disaster is non-existent, no one wants to be the last one off of the sinking boat and it won’t take much to spark the stampede. We’ll tread carefully as markets show early signs of substantive reversal. And, on a personal note, I’ll be out of the office next week. But I’ll try my best and update thoughts via twitter and e-mail if anything changes. Good luck trading and thanks for the continued interest and support – DR

http://www.dailyfx.com/forex/fundamental/daily_briefing/daily_pieces/opening_comment/2013/05/23/Yen_Continues_to_Rise_as_Nikkei_Closes_With_a_4-Year_Record_Decline.html

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