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US Dollar Can Regain Ground but Can it Produce a Real Rally?

By , Chief Currency Strategist
12 November 2011 00:30 GMT
US_Dollar_Can_Regain_Ground_but_Can_it_Produce_a_Real_Rally_body_Picture_5.png, US Dollar Can Regain Ground but Can it Produce a Real Rally?US_Dollar_Can_Regain_Ground_but_Can_it_Produce_a_Real_Rally_body_Picture_6.png, US Dollar Can Regain Ground but Can it Produce a Real Rally?

Fundamental Forecast for the US Dollar: Neutral

The dollar’s performance this past week was packed with volatility; but once again, the elevated activity level wouldn’t translate into consistent direction. From a fundamental perspective, the lack of course one way or the other is fitting as the economic docket was exceptionally light. However, we know that nowadays the data and event risk from the US doesn’t guide the greenback – the health of the global financial markets does. On this very important point, the jury is still out. We will see the market continue to mull over the balance of risk trends and funding market stability against the backdrop of headlines that constantly threaten both.

First and foremost for the coming week, dollar traders will need to keep tabs on underlying market sentiment. The bearing on risk appetite is important; but the potential for a trend from the benchmark currency rests with the momentum behind any shifts in optimism. The best way to measure the abstract notion of risk trends and its impact on the dollar is to monitor two things: the performance of the S&P 500 and the strength of correlations between different (but financially essential) asset classes.

As usual, the S&P 500 US stock index is our favored barometer for investor sentiment. The most recognizable and liquid stock benchmark in the world’s largest economy is a perfect gauge for global sentiment. Furthermore, equities themselves have an inherent bullish bias as the vast majority of market participants are buy-and-hold only. So, when confidence rises, shares are purchased. When pessimism takes over, they are sold. In correlations, we see how critical considerations (funding availability, expected rates of return, economic growth, stimulus and other market manipulations, etc) take over the broader flow of capital.

Over the coming week, the exceptional volatility we are carrying over and the growing appreciation for global stability threats will maintain correlation and keep speculative interests prone to surprising headlines. If we take a big-picture view of the world markets, the general trend will be a greater sensitivity to risk aversion. With the IMF warning the world could call back into recession, yields falling easing on a global scale, austere regulations requiring banks to carry more capital on hand and stimulus running into natural ceilings; conditions are ripe for a follow up to the 2008 crisis - though as second round will likely be less dramatic but more pervasive. This will leverage the response to negative developments and dampen the reaction to positive. That said, positive updates are more likely. Relief in immediate crises is something all FX traders have grown familiar with given the long-standing efforts by US and European officials. With Italy and Greece stepping back from the ledge this past week; the most likely catalysts for a credit crunch have been delayed. Unless we see something new pop up in Europe (or perhaps headlines that reflect an emerging market bubble crisis or an update that definitively speaks to an impending global recession), the market may be ‘encouraged’ that time has been bought, boosting risk and weighing the dollar.

Outside the tides of sentiment, we should watch the market’s treatment of the euro. There is growing discussion amongst key policy officials that suggests the Euro Zone may ultimately be culled. Whether this would make for a more stable region or not; it would undermine the euro’s appeal as an alternative reserve currency to its US counterpart. Less than 13 years old, changing the makeup and cumulative GDP potential of a currency calls into question its ability to stand the test of global cycles. This will be a background booster to the dollar (offer greater, indirect strength when its yields become more competitive). More immediate but less influential will be the data scheduled for release this week. Figures like retail sales offer modest adjustment to long-term growth, inflation draws the real issues. What does the Fed do should inflation continue to rise unchecked while economic activity stalls? - JK

--- Written by: John Kicklighter, Senior Currency Strategist for DailyFX.com

To contact John, email jkicklighter@dailyfx.com. Follow me on twitter at http://www.twitter.com/JohnKicklighter

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12 November 2011 00:30 GMT