special report

The U.S. dollar was pushed to a 15-month low (on a trade weighted basis) through the combination of a consistently neutral policy stance from the Federal Reserve, record low market interest rates, a broad rise in risk appetite, and emboldened calls for diversifying reserves away from the world’s most liquid currency. Some of these factors will prove temporary; but others are lasting concerns for the greenback. Knowing which dynamic holds which time frame and knowing which holds more bearing for the future will help trace out a fundamental road map for the dollar through what promises to be an active six months.

How Important is Growth?

From a purely academic standpoint, a currency reflects the health of the economy that backs it. However, nothing in the markets is as straightforward as economic theory would suggest. With the inclusion of speculative interests and the consideration that any value found in the currency market is relative; an economic recovery is no longer enough for a bullish forecast. For the dollar’s part, the U.S. economy has indeed reached the milestone of posting a positive quarter of growth and subsequently calling an end to one of the most severe recessions in living memory. But, what does this mean?

A concern that is gaining traction in speculative circles (and has long been a warning from policy officials) is that a return to growth does not necessarily mean any expansion will be particularly hearty. In fact, various central bank board members have suggested that the pace of recovery will be less than “robust.” Returning to the levels of output that defined the boom years before the financial crisis requires more than a few components that are still absent. Consumer spending is the most influential component of growth (accounting for approximately 70 to 80 percent of growth); and yet unemployment is expected to peak well above ten percent sometime in 2010 while wage growth is continuously being depressed by business leaders’ efforts to cut costs. This has in turn led to the savings rate rising to its highest level in years—exactly when the economy could use Americans’ historically generous spending habits. Add to this a lack of real lending to this sector, and the outlook for consumers’ contribution to growth looks anemic in the medium term.

Growth in the United States looks rather tame; but if its peers are mired in recession or are struggling with even weaker recoveries, the dollar could still come out on top. The IMF’s projections put the economy—and therefore currency—at a competitive position. According to the global lender, the U.S. economy will contract 2.7 percent through 2009 and grow 1.5 percent through 2010. This is distinctly better than the Eurozone’s meager 0.3 percent growth, and even the UK’s respectable 0.9 percent expansion through 2010. However, as a baseline for what we should really expect from growth, Japan is expected to expand 1.7 percent next year; and few market participants or economists are calling for the Japanese yen to outpace its counterparts going forward. This calls attention to our next concern: interest rates.

Interest Rates as a Gauge of Returns

Since the second to third quarter of this year, there has been a tangible but measured turn in global interest rate policy. While there are very few central banks that have actually increased their target rates (only the Reserve Bank of Australia and Norges Bank have moved among the industrialized world to hike rates while heading into the fourth quarter). However, here again, speculation comes into play. Though most policy makers have been very careful with their commentary, so as to prevent undo speculation through interest rate forecasting (which leads to unwanted volatility), the signs are nonetheless clear. The Federal Reserve is technically in the same boat as the European Central Bank, the Bank of England, the Bank of Canada, and others in that they have made it known that they will hold rates at current levels for the foreseeable future.

Comparing subtle context and initial efforts to remove policy stimulus, however, there is enough data for traders to compare progress on the groups’ respective hawkish policy efforts. Federal Reserve chairman Ben Bernanke has explicitly stated on a number of occasions that he would maintain the Federal Funds Rate at its lows until the middle of 2010. The market seems to corroborate such a time frame as the Fed Funds futures market does not price in serious potential for hikes until the second quarter of 2010, and overnight index swaps show little sign of an early move. On the other hand, a hawkish hue for central banks that are coming off an extremely loose stance does not necessarily begin with rate hikes. The withdrawal of fiscal stimulus and other abnormal means of financial support is an important step in itself and will no doubt bolster more accessible market interest rates. So far, banks are already repaying their loans, the Fed has set the end of its Treasury purchasing program, the implementation of the Private-Purchase Investment Program has moved some toxic debt off the US government’s books, and the central bank is testing the money market’s capacity as an intermediary to withdraw stimulus from the market without distorting balance sheets. This is arguably far more progressive than many of the United States’ peers.

Market Rates are the True Return

Most investors use the benchmark, or target, lending rates as a proxy for an economy’s expected growth, and the yield one can expect from general investment in an economy—and rightfully they should. However, when rates for much of the world are at or near zero and speculation is largely responsible for setting the interest in returns, something more concrete is needed. Forex traders know that there are interest rates attached to currencies, and that you earn when you are long a currency and pay when short. However, these rates are not benchmark lending rates. They are, in fact, overnight swap rates, Libor rates, bond rates, or some other investable market interest rate. For a true benchmark of US Dollar market interest rates, the standard-bearer is the three month LIBOR rate. In the fourth quarter, this key yield was just off a record low and at a significant discount to nearly every one of its counterparts (even the Japanese Yen yield, which is known to customarily be the lowest yielding currency).

How did it get to this point? Through the worst of the financial crisis, the Federal Reserve and the U.S. government reacted swiftly by pumping liquidity into the system, extending emergency loans and setting up a quantitative easing program, among other remarkable measures. This helped to pull the world’s largest economy out of its recession and assigned its currency a “safe haven” status that proved a boon during the worst of the capital market declines. Through 2009, these benefits turned to burdens as fear gave way to demand for yield. The dollar’s extraordinary low interest rates put it on the short-side of many currency trades. A potential, critical turning point for the greenback is the recovery of the United States’ market-defined yields. When the U.S. three-month Libor surpasses its Japanese counterpart, the debate over its use as a funding currency for carry trades will quickly disappear. This development will almost certainly take place before the end of the first quarter of 2010.

An Interim Correction in Risk

While we wait for the revival of U.S. rates, and long before the tables have fully turned in the dollar’s favor, there will likely be a significant correction in the underlying risk appetite in capital markets. The optimism that took hold of the capital markets since March has come almost exclusively through speculative interests. Stability has most certainly proliferated since the worst of the credit seizure and equity shock through the end of 2008; and that has in turn encouraged funds that were sidelined to find their way back into the speculative space. However, there are two parts to every investment: risk and reward. Risk has diminished but the outlook for returns remains bleak. Yields hardly cover lingering doubts about growth and credit markets. So, what has drawn traders in? The promise of capital gains.

In the absence of income through yield or dividends, fund managers have looked to make the classic retail trade of buying low and selling high. Through the months, the steady climb in many markets, as funds found their way back into the risk-bearing arena, drew more and more capital. However, after equities rallied over fifty percent and other markets climbed even further, doubt began to creep in. A critical look at the makeup of this rally suggests there is far more trader capital than investor capital. Traders are naturally looking for capital gains whereas investors are looking for annual returns through interest. Since the former’s profit is almost solely based on the underlying price, a correction is an event that can quickly erase profit, and therefore spark panic selling into a deeper retracement. If investors were more prolific, a bull trend would be far more sustainable.

Looking over the next six months, this is the most likely catalyst for a meaningful dollar rally. Trends do not maintain direction and pace for long without a consequential correction to shake out unstable funds and draw fresh capital back into the market. A specific catalyst can certainly help such a development; but a true reversal will likely come through sentiment itself. And, the subsequent rise in risk aversion will once again play to the greenback’s spurned safe haven status.

The World’s Currency

The final key concern surrounding the U.S. dollar’s strength over the coming months is the greenback’s status as the world’s reserve currency and its most liquid asset. Calls by officials and market commentators to diversify out of the dollar have been relatively consistent since the financial crisis gained momentum. Since World War II, the dollar has stood at the center of the world financial system as a means for promoting stability. Consequentially, central banks’ reserves were heavily weighted in dollars. Internationally traded resources were priced in dollars, and economies that couldn’t sustain a stable currency often pegged their own currencies to the greenback. However, through all of these ties, the recession and financial storm has called attention to the inefficiencies of this system. The fiscal and economic struggles of the US economy alone ripple across the globe.

So far, efforts to move away from the dollar standard have been very limited. Yet, as the recovery settles in, authorities may be more comfortable with embarking on the tedious and complex effort to diversify away from the world’s most liquid currency. However, this will is not a transformation that can occur within a few months. Realistically, the greenback will most likely remain the world’s dominant currency for many years. Though, depending on the prevailing mood of the market at the time, the definitive, long-term trend away from the U.S. dollar could certainly impact its health.

 
Technical Outlook

U.S. Dollar Index (Daily Bars)
 

Prepared by Jamie Saettele

One must know a market’s history before making a forecast.  The history of the U.S. Dollar relevant for making a six month forecast is displayed on the chart.  Markets move in a series of waves, with each series comprising either five or three waves (or a variation thereof).  The five wave movements denote the direction of the larger trend.  One such rally (five waves) began in March 2008 at 70.70 and ended at 88.46 in November 2008.  A sharp three wave decline (wave A) was followed by a choppy, complex rally (wave B).  Wave C, itself consisting of five waves, has been underway since March 2009 and may be complete.  If this interpretation is correct, then the next move in the U.S. dollar is up and price will exceed 89.62.  The wave principle does not specify how long the rally will last, but it is probable that the advance proves sharp (third wave in pattern since March).  Even the alternate pattern is bullish in the near term, suggesting a return to 81.50 (fourth wave of one less degree) in a second wave.  Additional bullish evidence includes divergence with momentum at each low since the break of the June low at 78.33.
 

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