US Dollar Surges, but Coming Week Will Tell us if it Continues Higher

Fundamental Forecast for US Dollar: Neutral

• US Dollar surges on strong February data, aftermath of Italian elections

• Greenback may consolidate ahead of key US Nonfarm Payrolls report

• Breakout trading remains top strategy as forex volatility surges

The US Dollar surged as markets turned volatile following Italian elections, pushing the Dow Jones FXCM Dollar Index (ticker: USDOLLAR) to its highest in over two years and its biggest single-week advance in sixth months.

Market tensions hit fever pitch as Italian elections reignited fears over Eurozone debt troubles, and the safe-haven US currency stands to do well if such uncertainty continues into the week and month ahead. A busy week of central bank meetings and the monthly US Nonfarm Payrolls report promises similarly big moves ahead.

The number one question is simple: was the sudden build in tensions a one-off event, or are we entering a time of greater uncertainty? The answer to this question may determine overall US Dollar outlook—particularly against “high-beta” currencies such as the Australian Dollar. We noted a significant build in forex market volatility as a key driver for the USD, and indeed vols finished near their highs as did the Dollar Index itself. If the first trading day of March is any indication, Dollar strength seems likely to continue.

Yet the Greenback will have to contend with the usual wave of early-month US economic data as well as Reserve Bank of Australia, Bank of Canada, European Central Bank, Bank of England, and Bank of Japan interest rate decisions. We’ll keep a particularly close eye on reactions to early-week US ISM Non-Manufacturing data as an important precursor for Friday’s NFP report, while Thursday’s ECB rate decision has the potential to force volatility across broader financial markets.

Why did Italian elections spark such sharp Euro losses as well as broad US Dollar and Japanese Yen gains? Put simply, a disappointing result highlighted the fact that Eurozone crises are far from over. And beyond that, there remain substantive risks to previously-complacent financial markets. ECB President Mario Draghi once said that he will do “whatever it takes to save the Euro”, but such grandiose promises could be put to the test on an important turn lower for Italian Bond markets. Traders will undoubtedly keep an eye on all ECB rhetoric and whether recent price action is enough to warrant a change in posture and/or policy from the central bank.

The sharp sell-off in the S&P 500 was telling, but the fact that stocks recovered most of their early losses underlines uncertainty surrounding financial markets. Friday’s US NFP’s data could help clarify some of the confusion surrounding US Federal Reserve monetary policy and outlook for the US currency and stock markets themselves. Yet recent months of labor market releases emphasize that almost anything can happen.

FX speculators for their part have made little secret of their fears of a sharper US Dollar reversal. CFTC Commitment of Traders data showed that Non-commercial traders are once again net-short the Euro and significantly cut US Dollar-short positions across the board. Yet the Euro breakdown failed to take out the psychologically significant $1.30 mark while the Australian Dollar similarly held above $1.02. What will it take to force the larger USD breakout?

We suspect that any further USD strength may need to come on S&P 500 weakness, and it will be critical to monitor risk sentiment in the days ahead. Fear is a much stronger emotion than greed, and stock markets tend to fall far faster in sell-offs than they rally through bull markets. If this is truly the start of a larger reversal for ‘risk’, it should play out fairly quickly. Keep a close eye on stocks and the US Dollar in the week ahead. – DR

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