Trading an Uncertain Dollar This Week

04/25/2011 10:49 am EST

Focus: FOREX

Brian Dolan

Chief Currency Strategist, FOREX.com

While the US dollar continues to sink against the euro and commodities continue to climb, currency traders are waiting intently on this week’s FOMC meeting for clues about future price movement.

The dollar is on the ropes ahead of the Federal Open Market Committee (FOMC) meeting and ended the week on the ropes after reaching new record lows against the Australian dollar, Swiss franc, and gold, while historic lows were on the radar for several other currencies.

The combination of easy monetary policy by the Fed and uncertainty with regards to the US fiscal situation weighed on the outlook for the greenback, while a positive start to earnings season saw equities surge, which resulted in heightened risk appetite.

The euro continued to climb higher despite ongoing sovereign concerns and talk of potential Greek debt restructuring. Ten-year yields in the periphery relative to their German equivalents widened to records levels, but that didn’t stop EUR/USD from reaching new 16-month highs of nearly 1.4650. Economic data released earlier in the week suggested continued strength in the core, keeping the euro supported ahead of this week’s CPI figures, which will be a key driver of interest rate expectations and the common currency.

The week ahead contains key events with regards to the US dollar with the FOMC rate decision at the conclusion of its two-day meeting on Wednesday. It will also mark a new era of direct communication between the markets and the Fed as the Fed introduces regular press conferences. The Fed’s statement will now be released at 12:30 Eastern and briefings will be held at 2:15 pm Eastern. The briefings are scheduled to be held four times a year and are designed to “further enhance the clarity and timeliness of the Federal Reserve’s monetary policy communication.”

We anticipate the Fed to maintain its commitment to follow through with the full amount of the asset purchase program through June and will be looking for comments that provide any guidance on post-QE2 policy. The advance Q1 GDP estimate is also scheduled for release this week and will be a key driver for the buck.

Euro: Some Say Down; Others Say Up, Up, and Away

In a week which began with rumors of a Greek default, one would easily presume to see euro weakness, however, this was easily trumped by news from S&P, which announced that it placed the US sovereign debt rating on negative outlook. After a few brief hours of deliberation, the market decided to dump their US dollars as quickly as possible.

Ultimately, this sent the EUR/USD to levels not seen since late 2009, leading many to wonder just how high this seemingly “one-way” trade will go…1.50, 1.60?

While it’s true that most of the pair’s recent rise can attributed to US dollar weakness rather than euro strength, we believe an imminent reversal of the USD’s fortunes is unlikely to change in the immediate future.

Moreover, the euro rose against nearly all G10 currencies this past week, with exception to the Swedish krona, whose central bank raised interest rates by 25 basis points (bps) to 1.75%.

NEXT: Important Euro Zone Data Due Out This Week

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Next week sees several key data events in the EU, highlighted by euro zone CPI, consumer confidence, and unemployment. With the ECB watching inflation like a hawk, all eyes will be on Friday’s April CPI number. Currently, the market is expecting headline inflation to remain steady at 2.7%. Should it surprise to the upside once again, it could prompt the ECB to act sooner rather than later, but even a number in line with expectations is unlikely quell the ECB’s fears of “second round” effects.

With the Fed and ECB seemingly on divergent paths and the euro’s recent ability to shrug off peripheral turmoil, we believe the single currency is likely to remain well supported in the near term. Therefore, we believe buying a dip towards 1.4450-1.4475 in search of a break back above the recent highs near 1.4650 and looking for a further continuation higher could be an idea worth considering in the week ahead.

A Weak USD Boosting Commodities

The greenback was slammed this past week as a US credit outlook downgrade, thin liquidity from the Easter weekend, and the upcoming FOMC rate decision kept USD longs on the sidelines. Loose Fed monetary policy continues to dominate USD direction, and until expectations for Fed tightening ramp up, the buck is likely to remain under pressure.

The weak USD week, however, underpinned the rally in commodities. XAG/USD (silver via the US dollar) reached multi-decade highs above $47, XAU/USD (gold via the US dollar) now trades above the $1500 mark, and oil prices resumed their uptrend to above $112 (West Texas Intermediate) and $124 (Brent crude oil), respectively.

To be fair, USD weakness was not the only contributor to commodity strength, as resurfacing euro zone peripheral debt concerns have instilled doubt in regards to the single currency’s long-term stability, sending additional flows towards tangible assets.

Considering all the external risk events surrounding the current market environment (uncertainty in Japan, Middle East/North Africa (MENA) region unrest, and euro zone periphery concerns) alongside declining confidence in fiat currencies, the path of least resistance for commodities seems higher.

Silver has consistently outperformed gold over the past year, as evidenced by the parabolic 50% decline in the gold/silver ratio to current levels near 30.

There are a number of factors underpinning silver’s near-vertical upside trajectory. Firstly, much of silver demand derives from industrial applications. The prospects for massive second half of 2011 reconstruction efforts out of Australia, New Zealand, and Japan are likely to keep industrial silver demand well supported throughout the year. Additionally, the simple fact that silver is a tangible asset—something that will not be lost in an accounting scandal or Ponzi scheme—has given market participants confidence in its role as a credible hedge in escalating “risk-off” environments.

It does seem a bit contradictory for XAG/USD to be tagged as both a “risk-on” and “risk-off” play, but its greater-than-30% rise over the past 30 days provides substantial evidence of its appeal regardless of market sentiment.

Accordingly, we think silver prices will continue to trend higher, although at a slower pace, underpinned by firm demand and its growing appeal as a safe-haven security.

By Brian Dolan, chief currency strategist, FOREX.com

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