Dollar Outlook Highly Constructive in Second Half of 2012; Bearish Equities

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By Joel Kruger, DailyFX Technical Strategist

Talking Points

Market conditions remain choppy and focused on EUR/USD and equities

US Fed outlook is critical for direction and recent shift suggests more USD strength

Eurozone crisis still very much alive and continues to pose risks

Situation intensifying in China, which exposes correlated commodity bloc and EMs

Markets continue to trade in choppy fashion and as of yet, we retain no clear short-term directional bias. The two key markets that we will focus on in Monday trading are EUR/USD and US equities. Should the Euro continue with the bearish momentum seen in Friday's trade and establish a daily close below 1.3000, then we will once again look for a bearish resumption in this trend and retest of the early 2012 lows by 1.2660. Similarly, the correlated US equity markets have also recently come under pressure, and should we see another bearish close here as well, we will expect this to translate into a risk negative market environment that fuels broader liquidation of risk correlated assets over the coming days.

There are 3 major fundamental themes across the continents that help to reinforce our overall bearish outlook for currencies and risk correlated assets: first, in the US, we have been seeing a very clear hawkish shift in the Fed's policy outlook. The sustained recovery in the US economy and healthy bout of economic data has instilled a stronger sense of confidence in the prospects for continued recovery, and this has in turn put the Fed in a position where they can start to focus on the longer-term structural problems within the economy and begin to contemplate a shift in policy with a path to higher interest rates. Ultimately, this development translates into a stronger US Dollar outlook on narrowing yield differentials and weaker global equity market on less attractive funding costs for equity investment.

Although European officials have taken great strides to combat the current Eurozone crisis, there are still many issues that need resolution, and with bond spreads remaining at uncomfortably wide levels, there is a good deal of risk associated with the region. While Greece has taken a bit of a backseat in recent weeks, threat of contagion to the other major Eurozone economies is very real, and larger economies like Spain are now in the spotlight. We would also remind investors that despite any sustained resolution to the Eurozone crisis, the possibility for real growth any time soon, given the amount of money thrown at the situation, is extremely limited and does not bode well for the medium-term. With this in mind, the risks seem to be tilted in the US Dollar's favor and do not indicate good things for equity markets.

Finally, negative news out of China is becoming a bigger and bigger story with every passing day. We continue to see evidence of a rapidly slowing Chinese economy and this slowdown could have a major global impact. Up until recently, there were those who argued that China would decouple from the US and European market crisis and would not be impacted. However, as we have been projecting for some time now, this is not the case, and we are now seeing a third phase of the global recession materialize in China. We contend that this will put a tremendous strain on correlated markets like the commodity bloc economies and other emerging markets. Many of the funds that had flowed into these markets at the height of the US and Eurozone crisis will soon reverse back into the more liquid US and European markets as things intensify in the east. This should once again translate into bullish US Dollar and bearish equity price action.

In light of these developments in the US, Eurozone, and China, we therefore recommend buying the US Dollar across the board on any form of a dip, and selling global equities on any form of a rally. We hold this outlook for the remainder of 2012. We do not expect an equity collapse like was seen back in 2008 and 2009, but the market does have a good amount of room to drop before considering a bullish shift in the trend.

ECONOMIC CALENDAR

TECHNICAL OUTLOOK

EUR/USD:

The latest round of setbacks have stalled ahead of some key multi-week support by 1.3000 and from here, we still can not rule out risks for additional consolidation above 1.3000 before considering bearish resumption. Ultimately, any rallies towards 1.3300 should be very well capped, while a break and daily close back under 1.3000 would accelerate declines.

GBP/USD:

Failure to establish any fresh momentum on the recent break above 1.6000, followed by an aggressive bearish reversal, now suggests that the market could finally be looking to carve a top in favor of a more significant decline over the coming sessions. Look for a break and close below next support at 1.5800 to reaffirm outlook, while back above 1.6065 would be required to negate.

USD/JPY:

The market continues to correct from the recent 2012 highs established at 84.20 several days back, and risks still exist for additional setbacks into the 79.00-80.00 area before considering a bullish resumption. Overall, our outlook is highly constructive and we see the pair in the process of carving a longer-term base ahead of the next major upside extension into the 85.00-90.00 area. We would therefore expect to see the shaping of a fresh medium-term higher low over the coming days somewhere in the 79.00-80.00 area. Ultimately, only below 78.00 delays outlook and gives reason for concern.

USD/CHF:

Our core constructive outlook remains well intact, with the latest setbacks very well supported by psychological barriers at 0.9000. It now looks as though the market could be looking to carve a fresh higher low, and we will be watching for additional upside back towards the recent range highs at 0.9335 over the coming sessions. Above 0.9335 should accelerate gains towards the 2012 highs by 0.9600 further up. Ultimately, only back under 0.9000 delays and gives reason for pause.

--- Written by Joel Kruger, DailyFX Technical Currency Strategist

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