US Dollar at Make or Break Levels: Time to Surge or Tumble

Fundamental Forecast for the US Dollar: Bullish

• US Dollar recovers, Dow Jones FXCM Dollar Index eyes 9900
• Forex correlations show US Dollar proxy for Dow Jones Industrial Average
• Has the dollar put in a meaningful bottom and risk trends a top with recent technical developments?

The US Dollar surged against all currencies except the Yen, boosted by a financial market flight to safety as the US S&P 500 posted its worst weekly loss in two months. Continued turmoil in Europe was the scapegoat, and the lack of confidence in European sovereign debt markets continues to spread throughout the global financial world. Continued deterioration in market confidence favors further US Dollar gains against the Euro and other key counterparts.

The early-week release of minutes from the recent US Federal Open Market Committee (FOMC) may set the tone for the coming week’s trade, and it will be important to watch for surprises from the US central bank. The key question on traders’ minds is whether the FOMC is poised for further monetary policy easing. A recent wave of encouraging economic data has arguably lessened pressure on Fed officials to enact policy easing. Yet persistently high unemployment and the impending US election year make Fed easing entirely plausible.

Politics remain a hot topic as Europe struggles with fiscal debt, and the US Government debt may once again come into focus as a key deadline for debt negotiation looms for the US Congress. Markets were thrown into turmoil this past summer as the US Treasury faced the real possibility of defaulting through political deadlock.

Investor sentiment will once again be put to the test as the so-called Super Committee decides on sizeable deficit cuts for the world’s largest economy. The bipartisan group of US legislators must announce at least $1.2 Trillion in deficit cuts by November 23rd, else there will be automatic cuts to key government programs in 2013. The likelihood of said cuts remains low, however; Treasury bond traders would like to see a sizeable deal to bring the US Government’s debt under control. Market sentiment remains fragile amidst clear concerns over the sustainability of massive government debts in the Euro area. We could conceivably see similar concerns on US debt if deficits remain on their current trajectory and US Government debt grows at an unsustainable pace.

Investor sentiment remains fragile on the great deal of uncertainty surrounding financial markets. We have long argued that the US Dollar stands to gain on such uncertainty, and indeed we see many fundamental and technical reasons for fresh USDOLLAR highs in the week ahead. The key question remains: is the trade too crowded?

The most recent CFTC Commitment of Traders report shows that large speculators remain heavily net-long the US Dollar against the Euro and British Pound. In fact, traders are near their most net-short the Euro against the US Dollar since the EURUSD bottomed through mid-2010. Can we see the Euro plummet to fresh lows amidst such one-sided positioning? It seems possible. Yet there is considerable risk that any short-term corrections in the EURUSD and broader ‘risk’ could bring sharp short-covering rallies.