Dollar on the Cusp of a Major Reversal Awaits a Clear Sentiment Signal

The burden to keep the dollar moving to ever-impressive heights has grown substantial over the past seven months.

Back in December, it would have been easy to label the single currency as being in an oversold position following a year-long tumble that was driven more by an appetite for yield than a meaningful shift in the fundamental strength of the global economy and markets.

A 3,200-point advance for the single currency against its primary counterpart (the euro) has neutralized much of this excess premium.

And, now the burden for further gains must be sourced by a significant deterioration in investor sentiment that further leverages the dollar’s position as a safe haven (despite its high cost with EURUSD at a four-year high); or there needs to be a tangible and remarkable shift in the fundamental tables that sets the dollar out as a superior source of potential returns (by either bolstering the dollar’s own strength or diminishing its peers).

Given the slow pace with which monetary policy and macro economic trends change, the immediate future of the greenback seems to be in the hands of unpredictable sentiment trends.

This leverages the potential for volatility and trend development over the coming week despite a relatively quiet economic docket.

With EURUSD stationed just below the same historical midpoint that acted as stubborn support in the initial decline, a breech from such a prominent pair could translate into an FX-wide move for the dollar.

With speculative interests in mind, we need assess the situation for a dramatic shift in the delicate balance between fear and greed. A quick scan of the horizon reveals that there are no specific catalysts to prepare for.

Yet, it is usually the case that the spark for risk trends was unscheduled – and it is oftentimes this surprise quality that truly amplifies its influence over the markets.

On the other hand, we can generally assess what concerns can encourage a meaningful response from across the speculative market.

At the top of the list is the ever-evolving situation in the Eurozone. The Friday before last offered the last bombastic announcement: that Hungary may be on the verge of default.

This concern has sense been defused and this is no doubt adding to the recovery in yield demand that we have seen last week.

After such a incredible announcement (a default in a fringe EU member could easily trigger a regional crisis); modest concerns like a protest, a weak bond auction or strained economic indicators may not cut it when it comes to driving the dollar to a fresh four-year high.

Something specific to watch out for are the results of the EU’s stress test of regional banks, Greece’s bond issuances as it relates to their need for financial assistance and downgrades to economies as well as banks.

Among the other, ongoing concerns, the health of China’s capital and credit markets could be a concern that overtakes Europe as a driver.

Sovereign debt risk amongst industrialized nations is another, constant issue given the need to withdrawal stimulus and the recent pressure markets have placed on assets.

And, while investor sentiment is the primary concern when it comes to trend development over the coming days, weeks and months; it is important to maintain a fair assessment of the dollar’s own fundamental health.

From a growth standpoint, the economy’s pace has eased off of its initial recovery phase, but the transition to stable and permanent growth is vital.

On this point, indicators like the leading composite, capital inflows, industrial production, construction and capital inflows will be important.

Where the dollar really lags however is in its interest rate potential. The market is pricing in a modest 37 bps worth of tightening in the coming 12 months.

On this front, the CPI data is particularly important as inflation is the one thing that can force tightening with level growth and financial uncertainty. - JK

 From DailyFX