US Dollar Surges as Dow Jones Tumbles – Reversal Risk High

Fundamental Forecast for the US Dollar:Bullish

The US Dollar (ticker:USDOLLAR) surged to multi-month highs amidst sharp losses in the Dow Jones Industrial Average and other key asset classes, setting the stage for continued strength. The Dow Jones FXCM Dollar Index easily broke psychologically significant resistance at the 10,000 mark and currently boasts its strongest 20-day appreciation since the height of the financial crisis in 2008. Momentum clearly favors the topside, but traders should be careful of sharp corrections ahead of what promises to be a critical week for the US Dollar and broader financial markets.

End-of-week US Nonfarm Payrolls data headlines foreseeable event risk for the world’s largest economy, but traders should be equally mindful of any surprises out of a European finance ministers meeting on Wednesday. Euro Zone tensions hit fever pitch this week as a failed German bond auction exacerbated sell-offs in Spanish and Italian bonds. Italy paid a whopping 7.81 percent for 2-year bonds in its most recent auction—up substantially from the 4.63 percent seen last month. Standard and Poor’s poured salt in the Euro Zone’s wounds as it downgraded Belgium’s sovereign credit rating for the first time since 1997. The doom and gloom in Europe was enough to push the US Dollar to significant highs, but the focus on Europe ignores key fundamental risks in the US economy.

US Treasury Bonds rallied despite news that the so-called Super Committee failed to agree upon fresh budget cuts ahead of its self-prescribed deadline. The lack of action from the group of legislators underlines the political acrimony in the current government and growing credit risk for the US Treasury. Global investors continue to flock to the relative safety of Treasury debt, but further credit downgrades or improvement in Euro Zone fiscal crises could push traders away from US debt and put the dollar itself at risk.

The next moves in Europe and trajectory of financial markets remains critical to forex price action as the USDOLLAR continues to surge on a flight to safety. 10-year US Treasury yields trade near record-lows (prices near record-highs). Yet any sudden reversals in markets could force US Treasury yields to surge and the dollar to fall from recent peaks.

US economic data will be important if it elicits strong reactions out of the S&P 500 and risky assets, but it may take significant bullish surprises to stop recent sell-offs. End-of-week US Nonfarm Payrolls data is likely to show that the domestic unemployment rate stayed near its lowest levels in the past six months as the economy added a net 120,000 jobs. Traders will look to the data to see if the US economy can continue growing despite clear financial market risks coming out of the Euro Zone. Watch for reactions out of US stock markets to guide subsequent moves in the US currency.

The US Dollar stands to gain further on continued stresses across financial markets. Yet the beginning of a new month often brings a change in trends, and seasonal trends suggest the Dow Jones Industrial Average tends to strengthen in the month of December. This onto itself is not a reason to go short the USD. Yet there is clear risk that the Greenback has hit heavily overbought territory.

Therecent cover from The Economist shows the Euro going down in flames. Such incredibly bearish imagery on a popular newspaper cover has often coincided with major tops and bottoms. Beware of the risk of an important short-term bottom in the EURUSD.– DR

Written by David Rodriguez, Quantitative Strategist for DailyFX.com