US Dollar Breaks Records/Resistance, Will The Rally Continue?

Records were broken and important technical levels fell with the dollar’s incredible rally last week. However, there was no specific top-tier indicator to trigger such a monumental move. So, is this just a remarkable false breakout or the inevitable fundamental shift behind a long-term trend change?

US Dollar Breaks Records/Resistance, Will The Rally Continue?

Fundamental Outlook for US Dollar: Bullish

- A Shift In Growth And Interest Rate Expectations Finally Lead The Dollar To A Major Technical Breakout
- FOMC Rate Decision Passes Without Incidence, Yet Speculators Are Still Hawkish On Rate Outlook
- Dollar Breakout Presents Significant Trading Opportunities In GBPUSD And Other All Majors

Records were broken and important technical levels fell with the dollar’s incredible rally last week. However, there was no specific top-tier indicator to trigger such a monumental move. So, is this just a remarkable false breakout or the inevitable fundamental shift behind a long-term trend change? To answer that question, we need to consider the fundamental buildup to the biggest one-day greenback advance in over five years and the longest overall sustained rally since the 2005 bearish reversal. On the outlook for growth, the second quarter GDP reading from the previous week seems to have placated the market; but that shouldn’t blind us to the first drop in growth since 2001 reported in the revision to the 4Q 2007 figure. Nor should it overshadow the significant burden on the outlook for expansion over the second half.

The Federal Reserve continues to warn the market about the downside risks to growth – and for good reason. The housing recession is still deepening, financial conditions have deteriorated to levels not seen since the peak of the credit meltdown and most importantly consumer spending (which makes up 70 percent of the economy) is in jeopardy. Americans are suffering rising unemployment (already at 4-year highs) and cooling wage growth (at more than two-year lows) which have contributed to sentiment near three-decade lows. If spending turns out as bad as this data suggests, a recession (two consecutive quarters of negative growth) could still be in store for the world’s largest economy. Next week’s docket will give a timely reading on that front with the July retail sales report – expected to repeat June’s modest improvement.

Perhaps the dominate force behind the dollar’s ultimate long-term direction though is interest rate expectations. Despite economic data that has been less than impressive, the outlook for interest rate hikes has gone relatively unchanged. Overnight interest rate swaps show suggest the FOMC will deliver 75bps of tightening through the coming 12 months. However, to sustain such a strong rally (even with the Fed’s major counterparts looking at considerably reduced forecasts), Bernanke and fellow Board Members will need to confirm they are genuinely hawkish – and relatively soon. The longer the central bank holds its hand, the more intense doubts will grow – and looking at Fed Funds futures, it might not be soon enough. Rate expectations from the derivatives show the probabilities for even a 25bp hike has dropped from 78 percent from a month ago to 38 percent last Friday. Certainly, Thursday’s CPI reading should help clarify the outlook. - JK

Visit our recently updated EUR/USD Currency Room for more resources dedicated to the US Dollar.