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The USD is finishing the week sharply lower across the board, with the most pronounced weakness coming against European currencies. The move lower was ostensibly triggered by concerns over losses in the mortgage-backed securities market, but those fears seem to have dissipated relatively quickly, as US equity markets broke out to new record highs in the second half of the week. But the dollar continued to fall as technical levels were breached and systematic momentum sellers reacted to additional weakness. The USD’s decline has now reached significant technical support levels in the US dollar index and I’m looking for the downmove to transition into a consolidation at the minimum, with decent potential for a corrective rebound in the USD.

The data out of the US was relatively light this past week, and we got some seemingly divergent readings on the US consumer on Friday in the form of lower June retail sales and a sharp increase in preliminary July Univ. of Michigan consumer sentiment. Retail sales ex-autos fell -0.4% vs. expectations of a 0.2% increase, but the decline ex-autos and ex-gasoline was less at -0.3%. Rather than the consumer running for the hills, they appear to have only stepped back a bit for a month. The strong rise in Michigan sentiment reflects a more upbeat consumer, buoyed by a solid labor market, rising wages, a strong stock market and a temporary decline in gasoline prices. The stock market surge was initially triggered by better than expected sales from major retailers, along with a roaring M&A market, reinforcing the notion that US consumers are hanging in there.

The concern over the sub-prime mortgage meltdown appears to have ebbed as quickly as it appeared, with markets largely discounting the risks of that very small slice (about 2.3%) of the overall mortgage market undermining the economy as a whole. In terms of its impact on the US dollar, the sub-prime market now appears to be a non-event, at least as long as equity markets continue to shrug it off.

Looking at the US dollar in technical terms, this past week’s plunge occurred when the US dollar index broke below 81.25 lows established earlier in April, and then accelerated to within a few points of the Dec. 2004 low of 80.40. For all practical purposes, that low has been tested (80.44 was Friday’s low) and is holding on the first try. I don’t rule out additional tests of the level, but major long-term lows line the way down to the psychologically significant 80.00 level. In particular, I would note the low of 80.05 reached in April 1995, which at the time coincided with a USD/DEM rate of 1.3450, which in turn translates to a EUR/USD rate of 1.4543.

More importantly, taking a step back from the dollar’s current slump and looking at the 40-year lifetime of the US dollar index, the 80.00 level represents a significant support level, with the index trading below it for only two months (Aug. and Sept. 1992), when a low was reached at 78.19. Looking at the current picture of the US economy (US equity markets at all-time highs; 2Q GDP now forecast to rebound to 3.5-4.0%; unemployment rate of 4.5%) and its prospects going forward (steady Fed rate outlook, with inflation potentially necessitating another hike), it’s hard to justify such extreme USD weakness. For those who have been following my commentary, you know I’ve been negative on the USD for many weeks now, but I’m now prepared to go out on a limb and suggest that the dollar’s decline is about to reverse.

The end of the move lower will probably not occur in a straight line, but will most likely entail additional downside probes, establishing a consolidation zone before momentum players shift gears and start buying USD’s. This view suggests taking profits on USD shorts vs. Europe and establishing US dollar longs on further tests lower, until more convincing price action confirms the reversal. I outline a concrete strategy for EUR/USD shorts in the Weekly Strategy.

Looking at the USD slump from the perspective of the Euro and Sterling, I’m also increasingly convinced that the market has too aggressively priced in further rate hikes from the BOE and the ECB, as well as virtually limitless upside to their economic outlooks. In fact, there have been some tentative signs that both Eurozone and UK growth are cresting, suggesting the potential for a sharp unwinding of market expectations for additional rate hikes in those countries. The major risk to this outlook is that USD-downside momentum takes on a life of its own and continues to see the USD sold, but this would be more of technical, market-driven dynamic, exaggerated by thinner summertime liquidity conditions. Fundamentally, though, the USD looks to be unjustifiably oversold. There is a lot of important data out next week, and Eurozone data in particular may take the wind out of the Euro’s sails.