US Dollar Making Progress on a True, Bullish Reversal

As has been the case for the full year, the primary fundamental concern for the US dollar going forward is the general bearing and force of risk appetite. From this, there are two concerns. As always, identifying and measuring the influence of potential catalysts is of primary importance; but now, we also have to gauge the currency’s relationship to risk appetite itself. In the past few weeks, while the dollar’s advance has been somewhat choppy and more prominent in certain pairs (EURUSD being the most remarkable example); it has come on strong local data and developed despite stability in other key risk-sensitive markets. This is a natural development considering markets held to congestion for nearly two months now at the top of an unprecedented rally; and the dollar has carried the brunt of the burden in funding this drive. Beyond just a general dissolution of correlations, though; there are fundamental reasons for the dollar to move up the yield spectrum. The United State’s economic recovery is among the strongest in the industrialized world, the Federal Reserve is actively reducing its stimulus and the financial stability in the US markets is comparable (if not more established) to its global counterparts. All that being said, a collapse in risk appetite that balances speculative interests through profit taking is still the most capable driver for the dollar. Not only would capital return to the safety of US Treasuries and money market funds; but it would be drawn out of emerging markets and other risky areas and put into the more liquid but yield-bearing instruments in the US.

For the more definable sense of risk in this coming week’s economic docket; there is plenty of data to feed the more established fundamentals trends. For interest rate forecasts, the market is targeting the Fed’s first hike around the middle of the year – in line with Governor Bernanke’s time frame. However, such projections are not set in stone by policy makers and traders know this. The FOMC rate decision on Wednesday will offer an update on how close a hike may be. Also, interesting in this event will be any mention of more measured changes to policy like the slow withdrawal of stimulus. Realistically, stimulus and interest rates can be adjusted separately. If financial aid is maintained and rates raised, it could support the economy, help dampen any inflation that may pop up and revive the dollar. Other noteworthy indicators on deck included the CPI stats, industrial production, housing starts and the vote to lift the deficit limit. – JK

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